Is Shorting UVXY, TVIX, or VXX the Perfect Trade?


Updated: Nov 30th, 2016 | Vance Harwood

The charts for long volatility Exchange Traded Products (ETP) like Barclays’s VXX, VelocityShares’ TVIX, and PowerShares’ UVXY are astonishing.

 

vxx-uvxy

I’m not aware of any other widely available securities that have declined like these.

Two questions come to mind:

  1. Why would anyone invest in these perennial losers?
  2. Why doesn’t everyone on the planet short these funds?

It turns out that there are reasonable reasons to buy these funds, and some people make money doing it. And a lot of people short these funds; it’s a crowded trade—to the point where it’s sometimes not possible to borrow the shares to short them.

It’s not easy money either way.

 
Risks of a Short Position

  • Unlike a short position in most equities fear is not your friend when you are short a volatility fund. When the market gets scared the equity declines are scary, deep, and fast—and volatility spikes up dramatically.
  • One characteristic of a short position is that its leverage moves against you if you’re wrong. When you first open a short position a 10% gain in the stock you shorted will cost you 10% of your position’s value, but the next 10% gain in the security will increase your loss by 12.2%. This increase in leverage increases rapidly if the security moves strongly against you. See this post for more information on this phenomenon.
  • Typically (75%+ of the time) the prices of long volatility funds like VXX, UVXY, and TVIX are battered by contango , but when the market tanks they turn into beasts.  First of all the VIX futures that these funds are based on spike up, second the VIX future’s term structure goes into a configuration called backwardation—which boosts the ETP’s returns, and the 2x funds often experience a compounding effect  that boosts their returns past their 2X benchmark.
  • Long volatility funds have not existed all that long, the first one was introduced in 2009, so we don’t have actual data for the earlier bear markets, but we do have historical data for the 2011 correction, where UVXY’s value went up 550% in a few months. In my simulation of UVXY’s prices that goes back to 2004, I show that that the prices of UVXY would have gone up 15X in the 2008/2009 crash.  Now you can see why some people are interested in going long with these funds.
  • In addition to the risks of typical market corrections and bear markets, a short volatility position is also vulnerable to a Black Swan type event. A major geopolitical event, natural disaster, or terrorist attack could cause a very large, essentially instantaneous jump, in the volatility funds.  The record one-day VIX jump so far was a 59% jump in February 2007, but in this post I postulate that a 100% one-day jump in the VIX is not out of the question. The VIX futures that underlie the volatility ETPs don’t track the VIX moves directly, typically the mix of futures used moves around 45% of the VIX’s percentage move, but with the 2X leveraged funds that still gives a 90% daily jump in their prices.  If an event like this happens when the market is closed there will be no chance for protective measures like stop loss orders to execute.  Even if the event happened during market hours conditions would be chaotic, and the market would likely shut down quickly.

If I haven’t managed to scare you off by now, the next section discusses specifics of initiating a short trade.

 

The Trade

  • These securities are always in the “hard to borrow” category, so it’s very likely at least a phone call to your broker will be required to create a short position. It’s also very likely you’ll have to pay an ongoing fee to borrow the shares.  Plan on the annualized fee being at least 7%.
  • You’ll need to have margin capability setup in a taxable account. Short selling is not allowed in retirement accounts like IRAs or 401Ks.
  • You’ll need extra cash / marginable securities in your account as margin. There are two different amounts required (which can vary by broker and by security), one to initiate the trade and another to maintain your position. The initial percentage will always be greater than or equal to the maintenance position.  Leveraged funds like UVXY and TVIX require extra margin.  The chart below shows Charles Schwab’s requirements for shorting ETFs as of 2-Oct-2016.

schwab-margin

  •  If your trade moves against you to the point that you don’t meet the maintenance requirements you’ll get a margin call from your broker. Not a fun thing. You have two choices at that point, either add more money / marginable securities to your account or reduce your short position by buying back some of the security.  Don’t expect your broker to be patient.

 
Managing a Short Position

  • If you hold a short position it’s critical that you have an exit plan. A few people might have a small enough position and enough margin to weather even the darkest bear markets, but most people won’t have the capital or the temperament to hang in there.  Emotionally it is very difficult to close out a short volatility position with a large loss, not only has your timing been bad, there’s also the near certainty that eventually contango will wear these funds back to levels that would be profitable for you. On the other hand, not having an exit plan raises the very real possibility that your broker will be the one closing out your position, likely at the worst possible time.
  • I haven’t looked extensively at protective strategies, but one thing to look at would be to buy out-of-the-money calls at strike prices much higher than the current trading value of the securities. That way you can limit or mitigate your maximum loss, even during a Black Swan. Essentially you’re buying an insurance policy with a high deductible.  It wouldn’t be cheap because the options would likely be expensive and usually expire worthless, but the peace of mind might very well be worth the cost.
  • One harsh reality of a short position is that while you are exposed to potentially very large losses the best case profit you can realize from your initial position is limited to 100%. For example, if you sell short $1000 worth of VXX your maximum profit can’t be more than $1000 because VXX can’t drop below zero.  And even with the ravages of contango VXX’s split adjusted price will never get all the way to zero.  As the security you short drops in value the percentage leverage of your position drops also, eventually approaching zero.
  • If your short has been successful at some point you’ll need to short additional shares to get your leverage and additional profit potential back up.  I quantify this leverage with a simple formula: Leverage =  P/Po   where P is the current price and Po is the price you initially shorted at. Let’s say you are comfortable with a leverage factor between 1 and 0.7.  If it drops to .7 then you would short enough shares to bring your leverage back to 1. So if you were initially short 100 shares at $10, you have a maximum profit potential of $1000 at that point…  If the price has dropped to $7, then your maximum additional profit has dropped to $700 and your leverage has dropped to 0.7.  To get your leverage and additional profit potential back to 1.0 and $1000 your need to short an additional $300 worth of shares (~43 shares).

Alternatives to a Short Position

There are some alternatives strategies that address some of the risks and restrictions of taking a short position.   Of course, they introduce their own limitations, risks, and restrictions.

  • ProShares’s SVXY and VelocityShares’ XIV and ZIV are inverse volatility ETPs that avoid the variable leverage and unconstrained loss aspects of a short position and are allowed in retirement accounts. In exchange for solving those problems, you pick up path dependency and volatility drag.  See these posts:  How Does XIV Work?, How Does SVXY Work?, Ten Questions About Short Selling  for more information.
  • Options are available for UVXY and VXX. Instead of going short on these ETPs you can buy or sell puts and calls. Buying puts eliminates the potential for an unconstrained loss, but the premiums are steep.  No easy money here either. One additional caveat, because of their frequent reverse splits longer term options will likely become “adjusted” options that have the number of shares they control changed and track a modified version of the security price. This happens in conjunction with the reverse splits.  Theoretically, no value is lost, but by all accounts these options become less liquid and the bid/ask prices widen. These options are American style, so with long positions you’ll always have the ability to exercise them, but caution is warranted.  For more on this see UVXY Reverse Splits.

Seller Beware

  I’ve had direct contact with people that have lost hundreds of thousands of dollars on both sides of these trades.  Honestly, I think considerably more is lost on the long side, but the blowouts on the short side tend to be quick and vicious.  Most rookies get greedy and risk being blown out by even a mild correction. If you can manage to hold (and rebalance) your short position long enough it’s a rational trade—but that’s a big if.

Related Posts



Wednesday, November 30th, 2016 | Vance Harwood
  • evo34

    The real problem is that if all hell breaks loose (and it might not even take that much to happen), the ETNs might detach from their underlyings and explode. More detail on pp. 22-23 here:

    http://static1.squarespace.com/static/5581f17ee4b01f59c2b1513a/t/561dc6f1e4b0b5f8adc9ca2f/1444792049785/Artemis_Q32015_Volatility-and-Prisoners-Dilemma.pdf

  • Hi Less, Cole’s stuff is entertaining but I don’t buy his doom & gloom. It’s well known that the 2X long and -1X inverse have to rebalance in the same direction (e.g., buy more when volatility goes up). This market, VIX futures is very liquid and is backstopped by the even more liquid SPX options. There are lots of institutions that would love to arb out a premium price in VIX futures relative to the appropriate strip of SPX options. The other dynamic is that there is lots of selling of VIX futures during volatility spikes. Holders are cashing in, trying to beat the inevitable volatility crash that comes later.

    — Vance

  • Options add a slew of new variables to the mix, but you can control your max loss with them vs shorting the stock. Never have to ask my broker to borrow and I can trade them in an IRA.

  • phil13pao

    Thanks for that Vance! Do you know why the weights on the VXX are not straightforward? For example, I would assume that the November futures weight increases by 5% because the roll period is 20 days. But at yesterday’s close the weight is 43% when it should be 45%.

  • Hi Phil, The mix is managed as a portfolio dollar value, not by the number of futures contracts. For details see https://sixfigureinvesting.com/2015/01/how-does-vxx-daily-roll-work/

  • phil13pao

    Ok! Thank you Vance! So with your example the new allocation will be 72 or 72.14 contracts?

  • phil skirball

    Hi Vance, Can you remind me if there is a chartable ticker and what it is for the index maintained by Dow Jones that UVXY is supposed to track on a daily basis? Something like VXSTVIX? I can’t find it anywhere. Thank you in advance

  • Hi Phil, UVXY tracks 2X the daily moves of SPVXSP (see http://sixfigureinvesting.com/2014/12/volatility-related-indexes-and-tickers/ for links to places where SPVXSP is broadcast). As far as I know you’d have to do the math yourself to get the appropriate 2X version of the index that UVXY tracks.

  • Joe Herzig

    Hi Vance, found this article (from other your other one); my thoughts exactly to short VXX when vix 30-50 on the (eventual) decline. Also keeping in mind a 15x worst case scenario cash position. However if factoring a 15x VXX spike, the hands down better trade would probably be a SPY long position or long anything assuming the company your buying still exists in that “dooms day” scenario!

  • Slade McPherson

    Why not just short UVXY, but back after a 50% profit, then sell short again? Repeat process throughout the year? Based on a Jan 2016 price of 150 and a current price of 10 this would have worked out beautifully selling and buying after every 50% gain. What am I missing, because I know this is a too good to be true scenario.

  • Hi Slade, 2016 did not have any volatility spikes to speak of. In the 2011 correction UVXY would have gone up 9X –consider what that would do to your strategy. The big challenge is not getting wiped out when (not if) volatility spikes up.

  • Slade McPherson

    Assuming a small percentage of your portfolio was/is dedicated to the strategy it wouldn’t wipe you out but be painful for a few months. The trade would have still been close to break even if not profitable by the end of the year. I would be more afraid of an extended bear market vs a quick spike in volatility given suck a quick reversion to the mean. So do you recommend buying XIV on big dips vs shorting UVXY? I’ve looked at buying puts on UVXY but the pricing and delta are obviously not in your favor. Last question, do brokers treat margin calls on these volatility trades because of their reversion tendencies?

    Thanks for the quick response, do you offer any volatility trading advice or newsletters I can subscribe to or know of any reputable newsletters with trades on vol? I’m just recently learning the vol trades available and I love your blog, some of what you say is over my head but you provide a ton of great information.

  • Don

    Over the last six or seven months, I’ve bought a lot of VXX and UVXY underlying shares because the market seems to be getting really complacent. Now my positions are down about 60%. I know at some point we’re going to have a spike, but I am getting nervous since my basis price for VXX is about $70. What do you think about selling calls against this vs just waiting until the next time the market panics? Most of my accounts are sitting in cash outside of these VIX ETF positions.

  • Hi Don, Without a market correction VXX & UVXY will have average monthly decay rates of around 7% and 20% respectively. https://sixfigureinvesting.com/2016/06/monthly-yearly-decay-rates-contago-losses-vxx-uvxy-vxx-vixy/ Without giving up most of your upside selling calls won’t reduce that decay rate by much. In my opinion holding these long vol funds for the inevitable vol spike is generally a losing strategy unless your timing is really good. The decay just kills you. You might consider the hedged vol funds XVZ and BSWN. They won’t have the spectacular returns that a VXX or UVXY would provide, but they’re a lot more likely to preserve your capitial until the spike actually happens.

    Vance

  • Don

    What about buying some puts on VXX assuming VVIX is low?

    Thanks!

  • Don

    Thanks Vance,
    I looked up the charts for BSWN and XVZ, and the volumes are extremely low, zero on some days unless I’m doing someting wrong when I generate the chart. Are the volumes really that low for these?
    Thanks,
    Don

  • These funds have very low trading volumes. They are liquid because their underlying is liquid. These ETPs by definition don’t do anything until the market crashes, so they don’t attract much attention. Posts related to these funds:
    https://sixfigureinvesting.com/2016/08/how-do-velocityshares-bswn-lsvx-xivh-work/

    https://sixfigureinvesting.com/2015/08/determining-liquidity-of-low-volume-etf-etn/

    https://sixfigureinvesting.com/2015/08/trading-low-volume-exchange-traded-products/

  • Luke T

    Hey Vance, at IB right now I see UVXY has borrowing costs of ~8% but TVIX has borrowing costs of ~3%. Do you know if this is normal to have such a large difference in borrowing costs for two almost identical ETPs?

  • Hi Luke, I don’t know the history on borrowing costs. I suspect the difference is just due to supply and demand. Because TVIX historically spent so much time trading below a dollar I think UVXY has become more popular for shorting. As far as differences I don’t see any substantive ones.

  • thecritic

    shorting at all-time historical lows of volatility would be too dangerous, no? vix 11.60 and hasnt really been lower than 10.8 as far as I know…

  • Certainly not an ideal time. Historically volatility picks up in January. However, now might be a good time to pick up protective long term OTM calls (e.g, S60) if you know you’re going to go short in the near future. Historic low for VIX is around 9.

  • thecritic

    OTM calls with $60 strike? I looked at last 3 years and VIX has been 10.3 at the lowest and 53.3 at its absolute height. They don’t even offer $60 strike… any other suggestion?

  • Sorry, since a direct short of VIX isn’t possible I was assuming you were talking about VXX. 16-June-17 VXX S50 calls are at $1.18. This would limit losses on a VXX short (assuming $25 price) to 100%

  • thecritic

    danke. makes perfect sense now.

  • energy11

    Hi Vance, I’ve been shorting SVXY and VXX and writing puts for the last 16 months. I’m down on my SVXY and up less on VXX but my puts have given me a 15% return overall for 2016. It’s the perfect trade except for the black swan event which will come sometime next year. Powder dry

  • HI Energy11, So you’re writing puts on both SVXY & VXX? Are the VXX puts significantly out of the money? Seems like otherwise they would have gone into the money a lot this year.

  • energy11

    yes Vance, out of the money. Some have to be rewritten if they’re too close.

  • Eric Roberts

    Hello, thank you for the valuable information. Is there any tax implications at the year end trading UVXY? I read few articles about it, but not very clear what is the tax impact end of the year. if you can give me example like if i make $100 end of the year as a short term gain how much tax do i pay. Thank you.

  • Don

    Hi Vance,

    Am I correct that VXX and XIV are inversely related, so if one goes up 1% in a day, the other one drops 1%? If that is the case, is it possible to setup a “straddle effect” by buying the same dollar amount of the underlying VXX and XIV when we anticipate a medium to large change in volatility but aren’t sure which way? Because of compounding interest, the leg that increases in value will move in larger and larger dollar amounts as the price rises than the losing one will lose. For instance, a $10,000 investment in each stock with 5% (exaggerated) daily increases in XIV and decreases in VXX, the XIV value will increase $10,500, $11,025, $11,576, but $10,000 in VXX will decrease to $9,500, $9,025, 8,574. The net value of the $20,000 portfolio would then be about $20,150. This is true regardless which way the VXX and XIV move. Am I missing something here?
    Thanks,
    Don

  • My understanding is that 60% of the $100 gain would be treated as long term gain (usually taxed at a lower tax rate), and that $40 would be taxed as short term capital gains.

  • Hi Don, VXX and XIV are only inversely related on a daily basis. For periods longer than a day it gets much more complicated. If volatility is high with lots of up and down movement XIV will tend to underperform, if the market is trending up or down then XIV will tend to overperform relative to VXX. For more on this behavior see https://sixfigureinvesting.com/2012/10/a-hat-trick-for-inverse-leveraged-volatility-funds/

  • Eric Roberts

    Thank you for the reply, Vance. I’ve scottrade brokerage account and my profit on UVXY trade is shown under short term capital gains. will it be shown correctly in my tax statement ? how can i make sure my accountant file the tax correctly. Cause as per trading rule for any brokerage ac, anything hold for less than a year is short term gain/loss.

  • Hi Eric,
    In the UVXY webpage http://www.proshares.com/funds/uvxy.html it specifies (in the fine print at the bottom) that this fund issues a K-1 form. My understanding is that UVXY will be considered under the 1256 contracts tax rules which don’t follow the same rules as equity trades. Of course I might be wrong, but ProShares owes you a K-1 form which your accountant can use to figure your taxes.

  • evo34

    Who is “Less”? If you honestly think arbing is going to be the top priority during the next legitimate crash, I have to say I lose some respect for you. This is coming from someone who has been short VXX for the better part of 8 years, BTW.

    My point is that if sh!t truly hits the fan, everyone backs away. The price of VXX can go as high as it damn pleases. Nothing to stop it. Shorting VXX is basically selling insurance against a total market meltdown. I’m not sure everyone understands that.