I have had several requests to do an analysis of a pair trade with the position being short VXX and short XIV. The idea behind the trade is to take advantage of the compounding effects caused by XIV’s daily reset feature that cause it to diverge from a true short. For example if VXX goes up 20% one day and then down 16.7% VXX is back to its starting point, but XIV would be down almost 7% after that sequence. The intent of the short VXX position would hedge the overall position against changes in market volatility.
For my analysis I assumed the short positions started with the same dollar amount, shorting 1000 shares of VXX and shorting enough XIV shares to provide the same dollar amount. The results putting the position in place 1-June -2011 are shown below:
The end result is a position that never goes more than a little positive, has a lot of volatility, and as of 11-Nov-2011 would have had a 12% loss.
For a long term performance picture I ran the backtest from 29-Jan-2009, when VXX first started trading. I used simulated XIV results for the data before its 30-Nov-2010 introduction.
This one gave a 46% loss. Not all starting dates result in losses. Starting the beginning of 2011 gives a nice 17% gain.
I think the biggest problem with this combination is that the leverage of a short position is variable. When the VXX price is close to the price that the short was initiated the leverage is around one, but if VXX moves significantly higher then the leverage gets higher (see this post), and the vice versa when VXX drops. The XIV short shows the same behavior.
Ideally a pairs trade would remove some of the volatility out of a position, but I think this combination is as tricky as a straight VXX or XIV position. The spreadsheet I’ve used to create these graphs makes it easy to try any start date after 29-Jan-2009, so if you think the key is when you initiate the position you can backtest your hypothesis. See this post for download information.