3:51 PM The VIX (VXX -6.7%) continues to slump, suggesting an ominous complacency in the face of struggling stocks. The VIX, however, measures the implied volatility of one-month S&P options, but tells nothing about forward volatility, which - as recently as late summer - was at a higher level than the day after Lehman went bankrupt.
If you looked at my previous posts, we tried to track the trail of the VXX and what it really means. My first trade on the VXX was in Q4 of 2011, when I decided to short or sell at the money calls on the VXX. Fortunately, the VXX is a pretty liquidity security and the options trade as well.
Why would I do that? When you sell options, you are “short volatility”, i.e. if volatility lessens, you are winning. So, if volatility on the VXX decreases, the option should be worth less, thus benefiting my short position. I am shorting volatility on an index that tracks volatility. Double bang for the buck!
So let’s think this through. Let’s say the movement in the S&P becomes normal, or some would say boring. Options on the S&P become cheaper, as volatility is lower due to the stability of the market. Prices of futures on the VIX goes down, alongside volatility, as expectations of options volatility also goes down. The market is calm and steady. The VXX, which tracks the futures, also trends down, and does not move up and down with any particular velocity. Hence, the calls that I’ve shorted decline in value, due to lower volatility in the market, and the VXX is less volatile, and the value of my calls go down due to contango.
The inverse should be true. If I buy calls, and the S&P starts to gyrate, the VIX moves upwards, and hence the VXX moves higher but in a volatile fashion, then I should get a double bang for the buck on the upside! Volatility is higher. Volatility of the VXX is also higher. Calls are higher. But, I still have the pesky contango issue.
Also, I have a lot of time value working on my side, which I’ll explain in a subsequent post, as I also discuss contango.
Okay, VXX is in Contango. Expect 3% monthly declines in the product. This is au naturel! Of course, as a reminder, when the markets go crazy, VXX could pop and as my friend Vincenzo says, “you can get your face ripped off!”
For the year Greenlight returned 2.9%, 2.7%, and 1.9% across their various funds. They have annualized 20% net of fees since inception. In the letter he discusses the European crises, some of his short positions (FSLR and GMCR) and his position that he shares with Kyle Bass on the weakening of the Japanese Yen. He also goes on to discuss Dell and Xerox is some detail.
But of Course There Is No Free Lunch! (And one important point)
If something is too good to be true, it usually is. Or look around the table when you’re playing cards. If you don’t know who the sucker is, it’s probably you! I have one important point to make about volatility and options. Options and futures decay over time. When you buy an option, it has an expiration date. The closer you get to the date, the less valuable the option, other things being equal. This means that your holdings will erode over time. Therefore if I’m buying VXX, it is natural for the value of my holding to decline over time. As we discussed in a previous post, the VXX tracks an index. The index is made up of near term futures. What happens when the futures are close to expiring? The answer is new futures are acquired that have an expiration date that are further out. Because these futures contracts are by definition worth more, given the longer expiration, they cost more to acquire. You can think of this as increasing the cost of the VXX, or lowering the overall value. The cost to acquire these new futures is called the “rollover yield”. You can google this term and you’ll see tons of explanations for it.
Here is the kicker: under normal conditions, the rollover yield is 3% per month. Therefore if I hold the VXX over a one year period, the value of the position should be lowered by 36%!! If you are betting against the VXX, this is like having the house tilted to your favor. Another metaphor: you are swimming with the tide. Yet another: you are playing with the extra attacker on the field.
So here’s the interesting “theory”. Hold the VXX and watch it erode… to nothingness…
So is the punchline we should simply short the Vix, a complicated, convoluted product that has the tendency to trade down? I asked two of my friends about this. The first said, “yes, you can short it, but occasionally you will get your face ripped off”. The other laughed at me and said, “go right ahead, if it is such a sure thing, I’m sure the market makers and other sophisticated investors won’t give you a beatdown!”
So, piecing it together from the beginning, I have the following:
The S&P 500 Index moves up and down with prices of the shares underlying the index —>
Investors buy put and call options on the S&P 500 —>
These options provide an implied volatility of the S&P index (i.e. the VIX) —>
Futures traders speculate on the future price of the VIX —>
These futures trades are compiled in an index, lovingly titled, “The S&P 500 VIX Short-Term Futures Total Return Index” —>
The ETF I purchase, the VXX, tracks the return of this VIX Futures Index.
So, in a nutshell, I’m buying an ETF of an Index of Futures intended to track the future direction of the VIX which loosely tracks an index of near term implied volatility derived from put and call options tied to the S&P 500 index. WTF?
No wonder brokers have hands on their faces.
But wait, there’s more… which I’ll explain in a subsequent post
What is the VXX? I am going to try to explain to you, as I understand it, in plain English, which will demonstrate why this is a really convoluted product.
1) The VXX is an ETF that tracks an index tied to near term VIX Futures prices. i.e., the index tries to track the movement of VIX Futures.
2) A VIX Futures contract is the price in which buyers and sellers of the contract believe the VIX will be headed in 30 to 90 days (i.e. near term)
3) The VIX itself is an index of the implied volatility of the S&P 500, as measured by near term option prices on the S&P 500.
4) Implied volatility is derived from what the price buyers and sellers are willing to trade the option for. This data is available now in many options trading programs and at Morningstar. In this context, implied volatility tells you what an S&P 500 optionholder believes, within one standard deviation (i.e. 66% probability), of how far up and down the price of the S&P 500 index can go in the next 30 days.
5) Lest we forget, the S&P 500 is an index comprised of 500 companies that represent a broad cross section of publicly traded companies.
Here is a 5 year chart of the Vix:
Note that the VIX typically revolves around 20. 20 can be interpreted as follows: in the next 30 days, I believe the S&P 500 Index has a 2/3rds probability of trading above 20% or below 20%. Then the VIX moves above 40, everybody freaks out, or perhaps everybody is freaking out which is why the VIX moves above 40. Regardless, this is when CNBC starts talking a lot about the VIX as a proxy for market fear, or volatility. High levels of volatility are bad. Typically the market moves like a giant bucking bronco, and investors, both big and small, are whipsawed and generally in bad moods. Most lose money.
The Vix, or Fear Index - What is it, and is this a broken product?
Technology investing is very volatile. Things can go really well for you, or really, really bad. New technologies emerge to disrupt the status quo. Market leaders fall behind, and new companies emerge with incredible speed. Recently, the equity markets have become increasingly volatile. One way to “manage” volatility is through an ETF called the VXX.
After the market went berserk this year (which it did a few times), I decided to some research on the volatility, or fear index. This was prompted when a friend of mine told me he had bought puts on the VXX (that’s the ticker symbol), because he thought it was a broken product. By broken, he meant that the product would, over time, fall to zero. More to come on this topic…