VXX (and TVIX, etc.) for Dummies
Originally drawn on the back of a napkin to explain to a fellow why the long VXX/TVIX play was silly in this market, and I thought it worth reproducing here…
Some still don’t grasp the idea that the long VXX (and TVIX, etc.) trade is a horrible way to play an expectation of rising volatility (when VIX futures are contangoed, which they usually are).
The cheat sheet above is about as simple a way as I could think of to explain why.
Nobody (and by “nobody” I mean NOBODY) knows with certainty where the market is going. The best we can hope to do is put the odds in our favor.
And the cheat sheet shows why betting against the VIX futures term-structure (ex. long VXX when futures are contangoed) stacks the odds against you.
If futures are contangoed and you’re right that volatility will rise, you will likely profit. If you’re wrong, you will lose. Fair enough.
But if volatility neither rises nor falls significantly, you will also lose. And that’s why the odds are stacked against you.
Unlike buying a stock where the possible outcomes are: win, break even, or lose, here our possible outcomes are win, lose, or lose more. If this were Vegas, you’re choosing to be the gambler instead of the house.
Got it?
So no more “long VXX/TVIX because volatility has to increase” talk please. That’s an opinion much better expressed with other instruments that are not actively working to destroy your hard earned trading capital.
Happy Trading,
ms
Note: none of this necessarily applies to using VXX to hedge a portfolio. While I don’t particularly like that idea either, it makes a lot more sense than making an outright bet against the VIX futures term-structure.
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Filed under: VIX & Volatility | 15 Comments
In your view, would the following super-simple system work: short VXX when VIX futures are in contango, go long VXX when VIX futures are in backwardation?
Hello Alex – that depends on what you mean by “work”. Yes, that would keep you on the right side of the term-structure bias, but it would also (eventually) result in serious volatility/drawdown. I would want to take a bit more sophisticated approach.
Side note: I’m not sure why an investor would want to short VXX, as opposed to going long XIV, on a directional (non-hedging) trade. First, VXX can be difficult to short. Second, (potential) future gains decrease as the position moves in your favor (b/c maximum short selling return = 100%). With a long XIV position, future gains increase as the position moves in your favor (b/c max long gains are infinite).
michael
There is a difference between short VXX and long XIV of about 5% per year I believe (due to slippage and other factors). However, like you said it is probably not practical to short VXX due to borrowing costs, daily rebalancing etc eating into that difference.
Hello James – over long time horizons there will be a huge difference short VXX vs long XIV b/c of the inherent difference between longs and shorts (long gains/short losses compound, short gains/long losses are limited to 100%). michael
Michael, I agree with that statement. But in addition to that phenomenon, XIV will actually lose compared to short VXX even if you rebalance daily without cost. This blog post explains it a little better than me.
http://matlab-trading.blogspot.tw/2012/03/hidden-cost-of-xiv.html
Hello James – that’s true (and something I’ve talked about on the blog before), but realistically I would expect anyone trading VXX/XIV in such short time frames (1-day or less) to find the unavailability of shares (to short VXX) + trading frictions a much bigger drag on returns than this small daily difference in performance between the two.
And anyone trading in longer time frames (more than 1-day) should be much more concerned with the compounding nature of longs (and lack thereof for shorts) b/c it’s going to be a much more significant driver of returns.
The point of all of that is to say that IMHO long XIV is a much better trade in the real world than short VXX.
michael
HI Michael, Nice visual. Might make the lights go on for some people.
– Vance
Thx Vance – kind words are always appreciated from one of my favorite bloggers. michael
Can you just replace VXX with SRTY (or any of the leveraged or inverse\leveraged ETFs) in your diagram?
How did you get the 82% and 18% numbers for contango and backwardation?
Hello Jon – by comparing the prices of the first and second month VIX futures contracts back to 03/2004. That’s a back of the envelope approach (and ETPs based on longer dated futures might have slightly different results) but it’s close enough for this demonstration. michael
thank you Michael for the article and response!
I am wondering if all of these short-VXX type strategies that are becoming popular will change this term structure dynamic in this future? Any idea why the contango bias exists in the first place and if it could become undone?