Hedging XIV - Research and Strategy | Part 1

XIV pushed to another all-time high this afternoon, closing for the fourth day in a row over $100. The "Fear Index"-short ETF continues to soar, returning 105% this year, 163% in the past 12 months, and 545% since starting its latest bullish trend in February 2016. These staggering returns have piqued the interest of many, myself included, and have prompted criticism from more. I want to take a deep dive into what makes XIV tick, hypothesize future price movement, and explore how to best hedge against its radical dips.

Some things to consider before starting this series: Along with the written articles, I am also publishing supplementary IPython Notebooks containing my research, calculations, and other miscellaneous code for anyone interested. As I am pulling all of my pricing information from the Quantopian research platform, a large portion of the notebook will only run on the Quantopian website. Please don't hesitate to reach out to me for help if you're having trouble understanding or running the code. (html Link - download or sign-in to view properly) (ipynb Link) Additionally, I have no professional financial experience; aerospace engineering is my area of study. Please reach out to me if you see any mathematical, semantic, or logical errors. I am long XIV at the time of writing. Enjoy...

Part 1 - Understanding XIV

For those unfamiliar, XIV "...seeks to replicate, net of expenses, the inverse of the daily performance of the S&P 500 VIX Short-Term Futures index. The index was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. The calculation of the VIX is based on prices of put and call options on the S&P 500 Index. The ETNs are linked to the daily inverse return of the index and do not represent an investment in the inverse of the VIX."(Yahoo Finance)

In other words: the market decides what the implied volatility of the S&P 500 Index is when pricing its derivative products. The CBOE Volatility Index (VIX) tracks this implied volatility value, tradable only through futures contracts. The S&P 500 VIX Short-Term Futures Index approximates the performance of long VIX futures contracts expiring in one month (by appropriately weighing the next two months' contracts). Finally, the XIV is an exchange traded product that tracks the inverse of that short term index. Simply put, XIV is a derivative of an index of a derivative of an index of a derivative of an index!(1)(2)

The convoluted construction of XIV can make it difficult to understand where exactly its returns come from. We'll examine each relationship and interaction, starting at the top with the S&P 500 and working our way down to XIV.

Options are traded on the value of the S&P 500, and using the costs of these options, among other parameters, the implied volatility of the underlying (S&P 500) is calculated. Implied volatility is different than realized volatility in that it is a prediction of future volatility, rather than a calculation on historic price movement. The VIX tracks this implied volatility value. Below are the graphs for the past three years of SPY, an ETF that tracks the S&P 500 Index, and the VIX index:

The VIX is often dubbed, "The Fear Index," so we can expect the relationship to be inverse. Visually that is confirmed; the peaks of one tend to correspond to dips in the other. Keep in mind that the VIX value is the actual S&P 500 implied volatility value, so it is effectively range bound and relatively mean-reverting. The S&P 500 is neither and tends to rise over time. The next relationship is between VIX and the S&P 500 VIX Short-Term Futures Index. The exchange traded product VXX will be used to represent the Short-Term Futures Index, as VXX tracks it.

Visually, there is somewhat of a direct relationship between the graphs of VIX and VXX. Peaks in one correspond to peaks in the other. However, something that differs is the tremendous loss of VXX value over time. Remember that the VXX (tracks the VIX Short-Term Futures Index which) simulates holding a rolling one month, long futures contract on VIX. Obviously, these contracts are not very lucrative in the long term...

The culprit is contango, and VXX has been suffering from its drag for the vast majority of its existence. Basically, contango is a futures market situation where the current price is above the future spot price. These two prices converge at the expiration date (as to not create an arbitrage opportunity), and when contango is taking place, the price converges downward to the spot price at expiration. Specifically for VXX, this means that the market's prediction for the future price of VIX is almost always higher than what VIX ends of being a month later. In the graph below, note that the green line (VIX Short-Term Futures Index ) tends to be above the red line (VIX) during normal circumstances. Imagine the green line having to collapse (usually) downward toward the red line every time futures contracts reach their expiration date, where the distance between the lines is loss. This phenomenon explains why VXX loses money in the long term. (4)

If it is well known that long VIX futures tend to overestimate implied volatility and lose money, then why don't buyers force the price down to something more profitable? The answer lies in the nature of the trade. The majority of long VIX futures are purchased for hedging purposes, as 'market insurance', rather than as speculative investments. Even during relatively small S&P 500 dips, it is not uncommon for the VIX to shoot upward 50% or 100%. These spikes make VIX futures extremely profitable, and in theory, cover the losses taken by one's market sensitive investments. In essence, VIX futures buyers are willing to pay a monthly premium to insure their portfolios.

XIV is simply the other side of the VXX trade on the VIX. VXX is going long on the index (buying the insurance) and XIV is shorting the index (selling the insurance).

Now knowing how all of the pieces of the puzzle fit together, let's step back and look at the big picture: XIV is inversely related to VXX. VXX is directly related to VIX (minus contango drag on VXX). VIX is inversely related to the S&P 500. Then it is reasonable to conclude that XIV and the S&P 500 are directly related, and the 0.841 correlation between them helps to confirm.

XIV and the S&P 500 tends to move in the same direction, but with very different magnitudes.

The stellar returns of XIV (during times of low market volatility) are in part are due to the same thing that VXX is plagued by. Because XIV is inverse VIX, it ends up greatly benefiting from the contango in the futures market, even during times when implied volatility is stagnant.

These findings are very interesting to me. XIV is a byproduct of the market, follows the market, and has a predisposition to be highly profitable whenever the market is not in turmoil. This investment has me questioning the "nothing beats the market in the long term" mantra.

In the next part, we will explore the dark side of XIV, examine its massive dips and drawdowns, and start to construct a hedged volatility-short portfolio.

Written by Logan Robertson

(1) Yes, XIV is an ETF inversely tracking an index (S&P 500 VIX Short-Term Futures Index) of futures derived from an index (VIX) of a Black-Scholes byproduct of the pricing of derivatives of the S&P 500.

(2) SVXY is a nearly identical product to XIV. However, I will focus only on XIV because its average volume is about double that of SVXY.

(3) Graph from: Cooper, Tony, Easy Volatility Investing. Available at SSRN: https://ssrn.com/abstract=2255327 or http://dx.doi.org/10.2139/ssrn.2255327