When Not to Go Short Volatility

The VIX is a supposed “volatility index”, but it does not really measure actual volatility. Instead, it measures what options traders think about volatility. All of the various investment vehicles that have popped up in recent years that are tied to the VIX have enabled traders to go long or short “volatility” with relative ease compared to a few decades ago.

And the short volatility trade has been among the most profitable, especially since the Fed, ECB, and BOJ started various flavors of quantitative easing in 2009. Betting on increased volatility has only worked a small fraction of the time.

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VXX and XIV are ETNs that allow investors to pretty easily go long or short volatility. VXX bets on a rising VIX, or perhaps I should more precisely say that it bets on rising prices for VIX futures since that is what it actually invests in. And XIV is a short VIX ETN which tracks the overall stock market very closely. So as stock prices rise, the VIX typically falls, and thus XIV goes up

What’s more, XIV gets a further boost from the contango in VIX futures. It goes short at a (usually) higher priced contract 3 months out and then covers when that contract is in its final month before expiration. Usually, that works out well for XIV investors who get to harvest that “contango”. Here is what the current term structure in VIX futures looks like:

So as long as the spot VIX Index remains low, and VIX futures retain their nice, steep contango, it is a gold mine to own XIV and harvest that contango. That is what has led some analysts to proclaim that XIV is a great solution as a permanent part of one’s portfolio. But there are times when XIV turns out not to be such a good investment, times when there is very little opportunity left to harvest.

This week’s chart helps us to see when those times are, and the key is to look at the price level of the highest priced VIX futures contract. When that falls to a low level, there is little opportunity left to harvest that contango, and there is also arguably too much optimism.

The price of the highest VIX futures contract is shown in the top chart on an inverted scale, the better to correlate with price action. When that price gets “below” 18 (high readings on the chart), that tends to mark a topping condition for XIV. In other words, there is little opportunity left.

Here is a longer term chart of that inverted scale price history of the highest VIX futures contract, versus the SP500:

Clearly, the better opportunities to invest in the stock market or to short volatility, come when the VIX futures are at really high prices (low chart readings). And when the highest VIX futures contract’s price falls into the teens, there is not much opportunity left to be short volatility, at least not profitably.

This is not to say that the market has to go down, nor that volatility has to shoot up right now. All it says is that risk/reward is now no longer in favor of those who have enjoyed and profited from shorting volatility in the recent months. Someday, the market will present us with a better opportunity.

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