By Keith H. Black, PhD, CFA, CAIA
Long positions in VIX are used to profit from increases in stock market volatility, which frequently happens when stock market prices are falling. As such, long positions in VIX can be used to hedge a portfolio of stocks that are correlated to the S&P 500 index. Long positions in VIX can profit from mean reversion when stock market volatility is at extremely low levels, such as below 20%.
Short positions in VIX are used to profit when the volatility futures curve is upward sloping, as well as to take advantage of the mean reversion characteristics of volatility. When VIX is demonstrating high levels of stock market volatility, such as above 30%, VIX is more likely to trade lower rather than higher.
Investors are cautioned that VIX futures, which are the basis for VIX exchange-traded products, can have very different characteristics than the VIX index published by the CBOE. For example, during a time period when the VIX Index has experienced 107% volatility, the front month futures contract may average 63% volatility, while the second month contract may average 45%. The front month futures have experienced a daily correlation to the VIX index of 0.84, while the second month contract has had a correlation of 0.76.
The shape of the futures curve may also have a substantial impact on the profitability of a VIX futures position. When the curve is in contango, futures prices at later maturities are higher than futures prices at shorter maturities. Long positions during times of contango are likely to lose value, even when the VIX index is stable or slightly rising. The opposite of contango is backwardation, which is when the shorter maturity futures trade at higher prices. Holders of futures contracts during times of backwardation may profit even when the VIX index is stable or slightly declining.
For example, the CBOE VIX index and futures closed at the following prices on January 6, 2012.
VIX Index 20.63
January futures 23.05
February futures 24.40
March futures 25.50
April futures 26.45
May futures 27.00
June futures 27.55
July futures 28.15
August futures 28.10
September futures 28.35
Investors with a long position in short maturity VIX futures, such as the January and February contract, face a steeply sloped (contango) futures curve, which is likely to cause losses unless the VIX index rises sharply in a short period of time. At expiration, the VIX futures should approach the value of the VIX index. With just a few days of trading remaining before the contract’s expiration on January 18, 2012, consider the following scenario. The VIX index rises from 20.63 to 22.00 before January expiration, a gain in the index of 6.6%. However, the January futures contract, which was purchased for 23.05, also expires at 22.00, giving the investor a loss of 4.5% in less than two weeks. The owner of a long January futures position faces even greater losses if the VIX index is unchanged before expiration, as the contract would be priced at 20.63 at expiration, a loss of 10.5% in less than two weeks.
Longer dated contracts often do not face such steep contango. Consider buying the September futures contract for 28.35 on January 6, and selling it in three months at April expiration. Assuming that the April contracts expire at the current price of 26.45, this three month holding period has a contango cost of just 6.7%. This lower roll cost comes at a price, though, as long dated futures have historically been less sensitive to a move in the VIX index.
Investors may prefer to take a short position in VIX futures during times of steep contango. Selling the January contract at 23.05 could earn a profit of 10.5% if the VIX index remains unchanged at January expiration. The risk to short positions in futures contracts, though, is that the VIX has asymmetric behavior, meaning that it moves higher more quickly than it declines. While the potential profit from 23.05 to 20.63 in just two weeks seems tempting, investors need to know that the VIX index could easily rise to a level between 30 and 40 in just two weeks if there are negative developments in the European sovereign bond market or a sharp decline in the US stock market.
Most VIX products are issued in the form of Exchange-traded Notes (ETNs). Exchange-traded notes are unsecured debt issued by the ETN sponsor, which is a commercial or investment bank. In effect, investors are lending money to the bank, with a promise of repayment based on the return to the underlying index, which is, in this case, some variety of VIX. Should the issuing bank receive a downgrade of the rating supplied by a credit rating agency or declare bankruptcy, the ETN can decline significantly in value, regardless of the change in the VIX index. ETNs can potentially become worthless, or worth much less than the calculated value, upon bankruptcy of the issuing firm. As debt issues, ETNs have a stated maturity date, often ten years from the date of issue. ETNs may also be redeemed early, if the ETN reached a contractually stated stop loss from the issuance price.
Exchange-traded Funds (ETFs) hold a pool of assets for investors that are segregated from the assets of the issuing firm. VIX ETFs would hold positions in futures contracts, where the value of investor assets changes with the value of the underlying portfolio. Until recently, the structure of ETFs seemed to be less risky than that of ETNs, as ETFs do not carry the credit risk of the issuing bank. ETFs holding futures contracts would have margin deposits held with a futures broker and incur counterparty risk to the combined membership of the clearing corporation employed by the CBOE futures exchange. This risk was previously considered to be minimal, and certainly less risky than the ETN structure. However, the recent failure of MF Global shows that even ETFs may have risk to the bankruptcy of a broker when customer assets are not appropriately segregated.
Investors with short positions in either ETFs or ETNs can profit from increases in credit risk and counterparty risk, as a decline in confidence in the structure or the issuer of the ETP can lead to lower prices.
Exchange-traded products with an objective of matching returns on a daily basis are not meant for long-term holding periods, as the return over long-term periods will not match the stated objective due to the compounding of returns. A product designed to match 2x daily returns will not match 2x monthly returns.
Keith Black has more than twenty years of financial market experience, serving approximately half of that time as an academic and half as a trader and consultant to institutional investors. He currently serves as Associate Director of Curriculum for the CAIA Association. During his most recent role at Ennis Knupp + Associates, Keith advised foundations, endowments and pension funds on their asset allocation and manager selection strategies in hedge funds, commodities and managed futures.
He is the author of the book “Managing a Hedge Fund,” as well as the co-author of the 2012 editions of the CAIA Level I and Level II textbooks. Dr. Black was named to Institutional Investor magazine’s list of “Rising Stars of Hedge Funds” in 2010. He earned a BA from Whittier College, an MBA from Carnegie Mellon University, and a PhD from the Illinois Institute of Technology. Dr. Black previously served as an assistant professor and senior lecturer at the Illinois Institute of Technology.