The first time I saw the weekly trades I gasped.  While most of my option trades have risk/reward ratios between 1:1 and 5:1 the risk reward of these trades is typically 50:1 to 100:1.  So, for a best case profit of $1000 I would need to put $50K to $100K at risk. A sharp market move against your position could wipe out all your capital—a 100% loss, in 3 days.   The minimum required capital to put at risk is not trivial—in order to make a meaningful profit after commissions and subscription costs are subtracted around $15K needs to be invested.

A typical trade using this strategy would look like this:

Trade time: 1-August-2012 12.57pm

SPY Weekly Options expiring 3-August-12
Credit Spread
Sell: Put-133 for $.06
Buy: Put-132 for $.04
At a Credit of: $.02
Limit order good for the day

With $15K in capital, you would buy 150 of these spreads.  Assuming commission costs of $18 (eoption.com), and factoring in one fourth of your $149.95 Trade Options Weekly monthly subscription cost ($37.5) your best case profit would be $244.5 and your worst case loss would be $14.755K.

Many of the Trade Options Weekly historical trades have only a $.01 credit, so the maximum profit on those would be $144.50.  Commission costs would be much higher with many brokers (e.g., Fidelity: $127, optionsXpress: $239).

The only happy ending for these trades is expiration out of the money.  With these razor thin margins there’s no room for closing out your position early at a profit.   Any sort of hedging strategy would almost certainly eat up all your possible profit.

How risky is this trade?

I don’t have intra-day data that far back, but SPY’s low on August 1^st,2012 was 137.40, the day the position was created.   So the short put (strike at 133) was at least 3.2% out the money when the trade was initiated.

The red bars in the chart below show the days where the S&P500 has closed down more than 3.2% in a two day period.

In the last 63 years there have been 247 instances of two day drops greater than 3.2%–an average of 3.9 times per year.   The risk looks about the same for each trading day of the week, so if the average trade is only the last two days of the week that will reduce the risk by 3/5ths–for an average of 1.5 times per year.  Some years (e.g., 1992 through 1995 and 2004 through 2006) didn’t have any drops this size most had at least a couple.

This isn’t particularly comforting…

This particular trade did fine, but it had a bit of a scare.  On the August 2^nd, with one day until expiration the S&P dropped as low as 135.58, the short put only 1.9% away from being in the money.  Drops of 1.9% in one day are more common—387 in the last 63 years.

However most of those drops were concentrated in bear markets.  Note how the frequency of these drops has increased over the decades.  We’re not imagining that the overall volatility of the market is increasing.

Most of the time, these trades will do fine, but if the market really does go south the position will be in trouble well before the short options go in-the-money.  In this example, if SPY drops to 133.5 with one day to go your position will be in the red $2400 (assuming 150 spreads and 15 as the implied volatility).  In most of these situations the mettle of your advisor will be critical.   Will they get you out in time?

If the market drop is fast and severe (e.g., overnight crash, terrorist attack, flash crash) there will be nothing to do—your positions will be blown out with no way to recover, your entire investment will be gone.   Of course almost everyone would be hurt badly in that situation, but it’s easier to recover when you’re not starting from zero.

In addition to these market driven eccentricities the actual calculation of the VIX has some quirks too.   The VIX is calculated using SPX options that have a “use by” date.   Every month, on the morning of the 3^rd Friday, the current month’s options expire.  This schedule of expirations forces the VIX calculation to periodically switch to longer dated options.

The VIX provides a 30 day expectation of volatility, but the volatility estimate from SPX options changes in duration every day.  For example, on May 1, 2013 the May SPX options, expiring on the  17^th, provide a 16 day estimate of volatility, while the June options, expiring June 21^st provide a 51 day estimate.   To get a 30 day expectation the VIX calculation uses a weighted average of the volatility estimates from two months—in this case May and June options.

The full blown S&P 500 VIX calculation is documented in this white paper.  It computes a composite volatility of each month’s options by combining the prices of a large number (> 100) puts and calls.  The CBOE publishes the result of these intermediate calculations as VIN for the nearer month of SPX options (not necessarily the nearest), and VIF for the further away options at one minute intervals.  These indexes are available online under the following tickers:

• Yahoo Finance as ^VIN, ^VIF
• Schwab $VIN, $VIF; historical data available
• Google Finance INDEXCBOE:VIN, INDEXCBOE:VIN; historical data available
• Fidelity:  no coverage

Using the VIN and VIF values in a  30 day weighted average calculation the final VIX value is determined.    Graphically this calculation looks like the chart below most of the time:

VIX calculation for 1-May-2013

In this example the VIX value for May 1st is computed by averaging between the May SPX options (VIN) and the June SPX options (VIF) to give the projected 30 day value.   Clearly the averaging algorithm used by the CBOE is not just a linear extrapolation between VIN and VIF; I provide details on this calculation later in the post.

Options can be  flaky in their last week, so when the VIN options are less than 7 days from their expiration the algorithm switches to the next pair of months.  The next chart shows the calculation right before the switch.

VIX Calculation 10-May-2013

The chart below shows the calculation on the next trading day when VIN switches to June options and VIF uses July options.  Notice how the green VIX bar is now to the left of the blue VIN bar.

VIX calculation for 22-May-2013

The VIX calculation is now outside the VIN / VIF values—an extrapolation.  If the term structure of the June / July options is significantly different than the May/June offering the resultant VIX value can jump significantly during this switch.  While the VIX calculation is in this extrapolation mode I suspect that the VIX’s weekend effects are stronger because any change in the VIN options will whip the VIX value around.

The chart below shows the special case situation of the VIX’s monthly expiration:

VIX Calculation 22-May-2013 — Expiration

On the Wednesday morning of VIX expiration the VIN SPX options are exactly 30 days from their expiration.  The result is that VIX = VIN and the special opening quotation SOQ and resultant final settlement value VRO only concern VIN options (June SPX in this example).    It doesn’t matter if an earlier series of SPX options hasn’t expired yet—they’re not included in the VIX calculation.

If you want to compute the VIX yourself using the VIN and VIF values you can’t just do a linear interpolation / extrapolation because volatility does not vary linearly with time.  Instead you have to convert the volatility into variance, which does scale linearly with time, do the averaging, and then convert back to volatility.  The equation below accomplishes this process.

The SPX options used for VIX calculations expire the 3^rd Friday morning of the month at 9:30ET.  See Trading SPX/SPXPM options  for more information.

The prices of SPY (S&P 500) starting in March of 2003 and of 2009 have tracked each other surprisingly well over a 6 year period.   The current market has managed higher highs each year, but then that advantage has evaporated by the Christmas holidays.

This year the market has already achieved the higher highs part of the pattern—and for the first time since this recovery begain the VIX levels between the two bull markets have become comparable.   If 2013 follows the 2007 pattern we will see a significant up-tick in volatility later this year—with the VIX reaching at least the low 30s.   In 2007 the market went into its sideways pattern around May 18^th.

• CBOE
  • The CBOE plans to extend VIX® Futures trading by over 5 hours—aligning with the London Stock Exchange open, and adding a 45 minute post settlement trading period 4:30 ET to 5:15 ET Monday through Thursday.
  • Two new volatility indexes, DLVIX and DSVIX are documented on the CBOE website.   These indexes were developed in cooperation with the French bank Société Générale and are now being used with two new European ETFs.   A quick look suggests these indexes switch VIX futures allocations based on term structure and VIX momentum.
  • Volume in VIX Futures continues to surge to record highs with April’s volume climbing 26% higher than March.  The year to year volume growth was 141%.   The chart below shows the open interest on the nearest 2 and the mid-term 4^th through 7^th month VIX Futures.

• VIX Central improved its historical VIX Futures term structure graphs by switching the time axis from contract months to time to expiration.   This change greatly reduces the chances of misinterpreting term structure differences across contract expiration boundaries.  See this post for more information.
• For the first time an inverse volatility fund—VelocityShares’ inverse short term volatility ETN XIV has taken second place in overall volatility fund assets under management (AUM) with $440 million.  The leader, Barclays’ VXX has $1.15 billion.  Third place goes to ProShares’ UVXY 2X short term volatility ETF with $344 million.  For more on inverse volatility see this post.
• Yahoo finance now reports Exchange Traded Product (ETP) AUM as net assets in their standard quote information and has made some other information available (e.g. shares outstanding, total cash) with special tickers.   The topics and example tickers shown below for SPDR’s JNK:
  • Intraday Indicative Value   ^JNK-IV
  • Shares Outstanding   ^JNK-SO
  • Net Asset Value ^JNK-NV
  • Estimated Cash ^JNK-EU
  • Total Cash  ^JNK-TC
• I recently found out about the Quandl data resource—a free source of downloadable price data  futures, stocks, rates, currencies, commodities; macro-economic data from FRED, BEA, DOE, Census, USDA, WB, UN, OECD; demographic and society data; and corporate financials.  There’s a lot of good stuff there.

Predictions 

• With both UVXY and TVIX trading well below $10 per share the question of upcoming reverse splits has returned.
  • I expect ProShares to reverse split UVXY 10:1 in May or June—they don’t want to lose the momentum that they have built up.
  • The last time around (December 2012) Credit Suisse waited until TVIX had dropped below $1 per share before doing a reverse split.  With $188 million in assets, I doubt they’ll let this product fade into oblivion, but given their track record of procrastination I’m guessing we won’t see a reverse split until TVIX is South of $1—perhaps in October / November.

White Papers

• “Easy Volatility Investing” by Tony Cooper
  • This paper took 2^nd place in the National Association of Active Investment managers’ (NAIIM) recent Wagner Award contest.   It provides a good overview of volatility trading and then does a thorough evaluation of 5 different trading strategies for volatility products: buy & hold, momentum, roll yield, volatility risk premium, and hedged.
• “Option traders use (very) sophisticated heuristics, never the Black-Scholes-Merton formula”   Haug & Taleb
  • I hadn’t seen this 2009 paper until recently.  Taleb claims that the practical impact of the Nobel Prize winning work of Black-Scholes-Merton on the options markets is significantly over emphasized.  He argues that structural relationships like put / call parity and compatibility between options combinations at various strikes (e.g., no negative butterflies) are the true forces setting options prices.
• “Volatility Trading: Trading Volatility, Correlation, Term Structure and Skew” Bennett & Gil
  •  Over 200 pages of wide ranging information—from covered calls to exotic options, to links between CDS spreads and implied volatility.  Something for everyone.

Not Recommended:  XXV TVIX XVIX IVOP CVOL XVZ

• I’ve added Citi Group’s CVOL and Barclays’ XVZ to my “Not recommended” list of volatility funds.
  • CVOL’s assets under management have dropped to $2.2 million and its bid/asked spreads are very wide.  Its strategy of trying to track volatility is sound, and their contango losses are less than UVXY or TVIX, but it’s just too small.
  • The intent of Barclays’ XVZ was to create a fund that was long volatility, but could be held during quiet times without losing much if any money.  XVZ attempted to do this by hedging a position in medium term volatility products with a short position in short term volatility.  Unfortunately for XVZ, the VIX Future term structure shifted about the time the fund was introduced in such a way that the hedging didn’t work and it has lost 30% in the last year.  XVZ might do OK during times of high volatility, but until it establishes some sort of track record in that environment I’d recommend staying away.   For more on XVZ there’s a good article “The Hedge That Wasn’t” posted by Season Investments.

A Message From Schwab

…………………………………………………………………………………………………

A denial of service (DoS) attack usually involves overloading servers with excess traffic.   My browsers weren’t even getting DNS addresses when I attempted to contact Schwab websites.

I doubt we’ll ever hear any specifics of this attack, but it would be interesting to know the sophistication of the attack, and the defenses Schwab had in place.

How does VXX trade? 

• For the most part VXX trades like a stock.  It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods.  With an average daily volume of 50 million shares its liquidity is excellent and the bid/ask spreads are a penny.
•  It has a very active set of options available, with five weeks’ worth of Weeklys and close to the money strikes every 0.5 points.
• Like a stock, VXX’s shares can be split or reverse split— 4:1 reverse-splits are the norm and can occur once VXX closes below $25.
• VXX can be traded in most IRAs / Roth IRAs, although your broker will likely require you to electronically sign a waiver that documents the various risks with this security.   Shorting of any security is not allowed in an IRA.

How is VXX’s value established?

• Unlike stocks, owning VXX does not give you a share of a corporation.  There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends.  Forget about doing fundamental style analysis on VXX.
• The value of VXX is set by the market, but it’s closely tied to the current value of an index (S&P VIX Short-Term Futures^tm) that manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts.  Every day the index specifies a new mix of VIX futures in that portfolio.  For more information on how the index itself works see this post or the VXX prospectus.
• The index is maintained by the S&P Dow Jones Indices and the current value of VXX if it were perfectly tracking the index is published every 15 seconds as the “intraday indicative” (IV) value.  Yahoo Finance publishes this quote using the ^VXX_IV ticker.
• Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of VXX diverges too much from the IV value.  If VXX is trading enough below the index they start buying large blocks of VXX—which tends to drive the price up, and if it’s trading above they will short VXX.  The APs have an agreement with Barclays that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep VXX’s tracking in good shape.

What does VXX track?

• Ideally VXX would track the CBOE’s VIX® index—the market’s de facto volatility indicator.  However since there are no investments available that directly track the VIX Barclays chose to track the next best choice: VIX futures.
• Unfortunately using VIX futures introduces a host of problems. The worst is horrific value decay over time.  Most days both sets of VIX futures that VXX tracks drift lower relative to the VIX—dragging down VXX’s value at the average rate of 5% to 10% per month.  This drag is called roll or contango loss.
• Another problem is that the combination of VIX futures that VXX tracks does not follow the VIX index particularly well.  On average VXX moves only 55% as much as the VIX index.
• Most people invest in VXX as a contrarian investment, expecting it to go up when the equities market goes down.  It does a respectable job with the VXX averaging percentage moves -2.94 times the S&P 500, but 16% of the time VXX has moved in the same direction as the S&P 500.  The distribution is shown below:

VXX% moves / SPX% moves (SPX daily moves of less than +/-0.1% are excluded)

• With lethargic tracking to the VIX, erratic tracking with the S&P 500 and heavy price erosion over time, owning VXX is usually a poor investment. Unless your timing is especially good you will lose money.

How does Barclays make money on VXX?

• Barclays collects a daily investor fee on VXX’s assets—on an annualized basis it adds up to 0.89% per year.  With current assets at $1.15 billion this fee totals around $10 million per year.  That’s certainly enough to cover Barclays’ VXX costs and be profitable.  But even if it was all profit it would be a tiny 0.1% percent of Barclays’ overall net income— which was $10.5 billion in 2012.
• From a public relations standpoint VXX is a disaster.  It’s frequently vilified by industry analysts and resides on multiple Worst ETF Ever lists.  You’d think Barclays would terminate a headache like this or let it fade away, but they haven’t done that even though 2 reverse splits—which suggests that Barclays is making more than $10 million a year with the fund.
• Unlike an Exchange Trade Fund (ETF), VXX’s Exchange Traded Note structure does not require Barclays to specify what they are doing with the cash it receives for creating shares.  The note is carried as senior debt on Barclays’ balance sheet but they don’t pay out any interest on this debt.  Instead they promise to redeem shares that the APs return to them based on the value of VXX’s index—an index that’s headed for zero.
• If Barclays wanted to fully hedge their liabilities they could hold VIX futures in the amounts specified by the index, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to accomplish that hedge.  If fact it seems likely Barclays might assume some risk and not fully hedge their VXX position. According to IndexUniverse’s ETF Fund Flows tool, VXX’s net inflows have been $5.99 billion since inception in 2009—and it is currently worth $1.15 billion.  So $4.8 billion dollars has been lost by investors and an equivalent amount by Barclays if they were hedged at 100%.   If they were hedged at say 90% they would have cleared a cool $480 million over the last 4 years in addition to their investor fees.  Barclay’s affection for VXX might be understandable after all.

VXX is a dangerous chimeric creature; it’s structured like a bond, trades like a stock, follows VIX futures, and decays like an option.  Handle with care.

VXX Backtest 2004-2013

Futures contracts were invented to allow producers/consumer of commodities to limit their business risk by locking in future prices.  In exchange for eliminating price risk they give up the potential for increased profits if markets later moved in their favor.  Traders wasted no time using futures for speculation, not because they somehow foretell the future, but rather because the low margin requirements for futures allows them to heavily leverage their bets.

Prices for futures contracts are constrained by arbitrage.  For example, if an arbitrager sees the premium for Dec 2013 E-mini S&P 500 futures rise above a certain point they will short E-mini contracts and buy the appropriate amount of stocks in the S&P 500 (or just short SPY).  From this point on they don’t care what direction the market moves—they are perfectly hedged—a risk free position.  The transaction is triggered when there is sufficient difference between the current S&P prices (the “spot” price) and the December contract bid price to compensate for their cost of capital to buy the stocks, account for dividends, and deliver the target profit.  Alternatively, if they think the futures price is too low, they reverse the transaction, buying the future and shorting the S&P 500.   Companies will differ in how much premium they require between the spot price and the futures price but the net effect is that E-mini prices trade between these boundaries—they aren’t a divination of the S&P 500’s value in December 2013.

For physical commodities like corn or natural gas the cost of storage is included in the futures pricing and in some cases seasonality.   For example, prices for corn might be depressed during harvest time because some producers want to move the product directly to market so they don’t have to store it.

Arbitrage for VIX futures is a much trickier thing.  You can’t buy volatility on the spot market and store it in your garage for a few months.  The best you can do is buy or sell the appropriate set of S&P 500 (SPX) options—the ones that expire 30 days after the settlement date, and eventually subject yourself to the settlement process.  Settlement is via the tweaky Special Opening Quotation (SOQ) process, which can’t even tell you ahead of time the full set of options that will be used for the settlement and in the last year has differed from the VIX opening price by as much as +4.27% / -3.8% on the morning that VIX Futures settle.

Contiguous SPX options are only available for the next 4 or 5 months, so the options associated with further out VIX futures expirations (up to 9 months out) are sometimes not even available.   Clearly market makers in VIX Futures must have other ways to hedge their positions (e.g., VIX futures spreads, VIX options, calendar spreads of SPX options).  In fact with the recent CBOE announcement of plans to start VIX futures trading 5 hours earlier than the current 8:15 ET, to coincide with European trading hours it appears they don’t even need the S&P 500, SPX options, or the VIX  to operate their market—at least for a few hours.

A quick look at historical data suggests that VIX futures tend to trade at a 3% to 9% premium to the VIX level of their associated SPX options.  A chart with April 10, 2012 and April 11, 2013 data is shown below:

Data from VIX Central and CBOE VIX Term Structure

Since the notional value of the SPX options market is currently much bigger than the VIX futures value it is reasonable to assume that the VIX futures tail does not wag the SPX options dog.   So the question becomes, what sets SPX options prices, and indirectly their implied volatility?  Are the market participants seers or are there other factors at work?

First of all, by any measure SPX option implied volatility is terrible at predicting future volatility in any way other than general reversion to mean.  If current volatilities are very low they predict an increase in volatility, if really high they predict it will drop.  Short term they predict that tomorrow will be like today—brilliant…

Insurance is a better model for predicting SPX option prices.  Investors use option strategies for price protection (e.g., fully hedge any market moves below a certain price), and as assets that reliably go up during serious market corrections or panics.  Even if your puts aren’t in-the-money, they still go up a lot when volatility spikes.

An insurance company doesn’t try to predict when you will have losses on your house or car.  It looks at the statistics and then charges a constant monthly rate they believe in aggregate will cover the claims they receive and over time deliver a reasonable profit.   I think the VIX Futures market looks a lot like an insurance provider.

Two final notes:

• VIX Futures do have one seasonality pattern —the Christmas effect.  Typically December VIX futures are slightly cheaper than the surrounding contracts because volatility around that time tends to be low—a lot of people are on vacation, and the market is closed for several holidays
• The VIX Futures term structure chart during quiet markets has gotten more linear in the last couple of years.  This shift has dramatically increased the contango in the mid-term futures—much to the chagrin of the XVIX, VXZ, and XVZ ETNs. On the other (inverse) hand ZIV is a happy camper.   Eli, from VIX Central speculates the curve straightened because there used to be a low risk trade of shorting a VIX future month right before it started sliding down the steeper portions of the curve, while being long the month after it as a hedge.  This trade might have just gotten crowded or perhaps the increased volume in the later month futures driven by the volatility ETPs made the market more competitive.

VIX Central

Term structure graphs, like the VIX® future charts on VIXCentral.com are very useful.

VIXCentral

At a glance you can see futures prices for multiple months and determine whether the market is in backwardation or contango.  The slope of the curve gives a quick estimate of how much roll yield you can expect at various parts of the curve—assuming the market mood stays the same.

However some subtle errors sneak in if you aren’t careful.

A typical term structure graph has prices on the vertical axis and calendar months on the horizontal axis.

However futures typically don’t expire on month boundaries, so sometime in the current month futures expire, to be replaced by next month’s as the near term futures.  Nothing on the chart indicates this.  It’s kind of like the chain on your bike skipping a tooth—if you’re not paying attention you might not notice.   In the chart below it appears that on March 20^th, 2013 the term structure shifted up almost 1.5 points for most months.

VIXCentral

But on the morning of the 20^th the March futures expired, so all the futures shifted to the left by one on the chart; the “April” price point on the 19^th, became the “March” price point on the 20^th.   The chart below gives more detail.

The next chart tells the real story of what happened to the term structure between the 19^th and the 20^th.

The short term portion of the term structure shifted down significantly, and the mid-term futures (July through Oct) barely moved.  Whenever comparing curves be wary when you cross contract expiration boundaries.

I ran into this problem when evaluating the performance of VelocityShares’ ZIV from March 5^th through April 3^th, 2013.  The contango on the mid-term futures that ZIV shorts had been steady at around 3% per month since March 5^th, however after almost a month ZIV was only up 0.17%.   At first I thought it might be volatility drag, because there was a fair amount of chop during that period, but looking at the non-inverse ETN VXZ—it was only down .55% for the period, so if there was volatility drag it wasn’t significant.  A look at the calendar based term structure below showed a mid term curve that shifted up strongly over time, suggesting that ZIV should have lost much more than it did.

VIXCentral

But this curve is comparing apples and oranges—the April data point has March futures combined with April expiration futures.   Correcting for that we get the curve below:

Now we see why ZIV hasn’t moved.  The July/Aug/Sep/Oct futures contracts it holds have barely moved from last month’s values.   The contango in the term structure has been cancelled by a general rise in prices.

When comparing term structure curves between dates be careful.  If you span expiration dates the comparison is probably lying.

The last time the CBOE’s VIX® index closed above 30 was December 8^th, 2011.  In the 16 months since the split adjusted price of Barclays’ VXX has dropped from 174.84 to 20.34—an 88% drop.  None of the 14 other USA based volatility funds that are designed to rise with volatility increases did well, the best being Barclays’ VQT, which eked out a 5.5% gain—while the S&P 500 went up 26%.

The worst of the short volatility funds, Barclays’ XXV went up 21%, the best, VelocityShares’ XIV went up 326%.  This sort of performance gathers attention and assets—XIV is now the second biggest volatility fund with $421 million in assets.   ZIV, VelocityShares’ mid-term inverse fund quadrupled its assets from $10 million to over $42 million.  The chart below shows the assets under management of the current 20 volatility funds—the green bars are 27-March-2013 numbers.

Data from IndexUniverse

Buying XIV or ZIV isn’t the only way to short volatility.  Not counting investing directly in VIX futures there are at least four different ways to go.

The most obvious strategy is to just short one of the long funds.

Direct Short (VXX, UVXY, TVIX, etc.)

• The primary advantage is that there is no compounding errors or path dependencies.  It doesn’t matter what price path these securities follow, the end result of the position will be the same.  However there are a host of disadvantages.
• Losses can be much greater than your initial investment. If a volatility spike comes along (and they tend to be fast), you can get in trouble in a hurry.  No respecter of  market hours,  the volatility climate can change overnight.
• These shares are usually hard to borrow—other people have the same idea
• You can’t short shares in an IRA account
• The best you can do with your initial position is a 100% gain (security goes to zero).  To get more than 100% gain from your initial position you need to short more shares.
• The leverage factor is not in your favor.  After starting with a leverage of 1X when you place the short, the leverage goes below one if the security drops in price, and above one the security moves against you.

To address investors that can’t / won’t short, or don’t want to babysit their positions as closely Exchange Traded Products (ETPs) are attractive.  There are two different implementations:

1. Daily Resetting Inverse Funds (XIV, SVXY, ZIV)
   • The primary disadvantage is compounding errors.  If the security thrashes around a lot your position will drop if value even if the long side ends up right back where it started.   However, there are a lot of advantages.
   • You can’t lose more than your initial investment.  The fund might terminate, but it won’t go below zero.
   • The leverage is a consistent 1X and your profits are unlimited—the daily reset sees to that.
   • They are easy to invest in.  There’s no problem using these in most IRAs.
   • In trending bull markets these funds can do better than their leverage factor.
2. True Short Funds (XXV, IVOP)
   • The primary advantages of these mostly forgotten Barclay funds is that they do not have compounding errors and you won’t lose more than your original investment.  There are a lot of disadvantages.
   • Your maximum profit is less than 100%, probably much less, because these funds can’t go higher than $40 per share.  There’s a feature…
   • Like a true short, these funds have variable leverage.  When things are going bad for you the leverage gets higher.  Because of this accelerating leverage these types of fund are prone to termination events (IVO), or get dangerously close (IVOP).

At first glance, options are the ideal approach for shorting volatility.  They have no compounding error, limited downside, good leverage, and reduced capital costs.  The bad news is that Wall Street knows this, so profits are tough to come by.

Option Strategies (VIX options, options on VXX, UVXY, SVXY, etc.)

• For an option based strategy you should figure out how much movement you need in the underlying before your position breaks even.  Obviously things like time to expiration and implied volatility complicate this analysis, so I usually start with the easiest case—position value at expiration.
• For example, consider a long put on UVXY using data from 6-Mar-2013:

• UVXY is at 9.47 and the Jan 2014 puts (318 days), with a strike price of 9 are selling for 4.55.
• The prices on the puts look reasonable; the IV is around 150 which is a pretty good match to the 22 day historic volatility which is running in the mid-150s.
• For this trade the UVXY break even point is around 4.55—in January 2014.
• Obviously just breaking even isn’t enough. To get a good profit, say 80% of your investment you need UVXY to drop another 3.64 points, down to $0.81, a 91% decline.  That’s certainly possible, even likely for UVXY—unless the market has bearish period during 2013.  UVXY can really skyrocket during a sustained correction, so if something similar to the 2010 Flash Crash, or the 2011 Euro worries happens you would be lucky to break even.
• Bottom line, if you’re buying puts you’re probably not minting money.  Of course if you predict a period of low volatility correctly then you’d do great, but just randomly buying puts will probably not work that well.  If you think you are going to average down your basis during spikes by buying cheap puts then you might be surprised. The prices on the low strike puts will stay surprisingly high because their IV will spike too.

• No sane person would write naked calls on a long volatility product, but spreads could be used to harvest premium and limit potential losses.   The big problem here is call skew—the IV of the calls rises rapidly with the higher strikes.  Again, Wall Street is ahead of the game and to get interesting profits you’d have to go with wide spreads, increasing your risk considerably.

Eventually there will be another volatility spike that will slam short volatility positions, but predicting when that spike occurs will be tough—and it might be years off.   The current set of long volatility products get killed by contango during the 75% of the time that things are quiet, until that changes I think investors are going to be much more successful going short volatility—bailing out when the market gets nervous.