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.
There are three viable choices in inverse volatility ETN/ETFs. ProShares offers SVXY an ETF (-0.5X inverse of VXX), VelocityShares offers ZIV (daily percentage inverse of medium-term VXZ), and EXIV which is tied to short European VSTOXX futures.
In rating the Barclays, VelocityShare, and ProShares funds I think there are four primary factors:
- Liquidity (small bid-asked spreads, getting good fills on orders)
- Tax treatment
ZIV’s daily volume is generally around 80,000, and its spread runs in the 7 to 10 cent range—not great, but it can handle good size trades (thousands of shares), without getting jerked around. At times ZIV has been my primary trading vehicle for inverse volatility. Lots of zip, with lower drawdown risk than the short term products. For more on ZIV see Trading Inverse Volatility with a Simple Ratio.
On leverage SVXY is simple, their goal is -0.5X of VXX’s daily percentage moves.
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.