I used to share stock tips with my brothers-in-law. Before the tech crash I could offer up a few stocks I liked, and they would often make some money. The crash painfully ended the easy money and I moved onto index funds. They didn’t think indexes were near as much fun.
One Easter one of my brothers-in-law asked what I was investing in. My response was “inverse volatility.” I might as well have said pixie dust. I stood there wondering where (or if) to start. First you have stocks, then you have the S&P 500, then you options on the S&P 500, then you have implied volatility calculations, then you have futures on volatility, then you have ETNs with rolling mixtures of futures on volatility (VXX), and then you have the inverse (or the short) of that. We looked each other in the eye and wordlessly agreed that we wouldn’t start.
I like inverse VXX/VXZ investing. It’s seldom boring and over the long run the advantage is on your side. Volatility has a return to mean behavior, and volatility futures are almost always in contango—which erodes the value of VXX. If you buy inverse volatility when the VIX is relatively high, your chances of making a good profit eventually are very good.
Currently, there is only one viable choice in inverse volatility ETN/ETFs, ProShares’ SVXY, an ETF (-0.5X inverse of VXX),
In rating volatility funds I think there are four primary factors:
- Liquidity (small bid-asked spreads, getting good fills on orders)
- Tax treatment
ProShares’ SVXY has very good liquidity and an acceptable leverage level of -0.5X (-1X would be better). From a risk viewpoint SXVY’s -0.5X leverage significantly reduces the odds of a XIV style killer downturn, but it is still sensitive to the end-of-day dynamics of the VIX futures market settlement process, which happens around 15 minutes after the equity markets close. SVXY requires K-1 style tax treatment, somewhat more complicated than stocks but it may offer 60% long term tax brackets regardless of the holding period.
It turns out that the daily percentage leverage of a short position is a variable which changes as the equity changes in price. For example, if you short XYZ stock at $100, the first $1 move, either way, delivers 1X leverage—you gain or lose $1, which is +-1/100 = +- 1%. But the further you get from that initiating price, the more the daily leverage changes
For example, imagine after you sell XYZ short at $100 it drops like a rock to $2/share. If it drops the next day from $2 to $1.5, it’s a 25% daily move—but the value of your short position only changes from $98 to $98.5 per share. That’s a 0.5% move and the leverage, 0.5%/25% is only 0.02X. Conversely, if XYZ moves to $150 after you short it at $100, a $1 daily move down (0.67%) changes your position value from $50/share to $51/share—a 2% move which is 2%/.67% = 3X leverage. The graph below shows this relationship.
Regarding risk, these are volatile products. They will get hammered when volatility spikes up. For example, on February 5, 2018, XIV dropped 96% in one day and was terminated a few days later.
Although all inverse volatility funds benefit from the normal contango term structure of volatility futures, they aren’t reasonable buy and hold choices for investors. Investors should hedge, or go to the sidelines if the market looks “toppy”. All your gains can evaporate in a big hurry if the market corrects or crashes.