Schaeffer's Trading Floor Blog

Derivatives of Derivatives: A Closer Look

Analyzing leveraged tracking vehicles on volatility ETFs and ETNs

by 4/3/2014 7:34 AM
Stocks quoted in this article:

All is right in volatility ETF/ETN world! Or all is wrong it depends upon your opinions on volatility derivatives.

After 2.5 months or so of persistently decent volatility sentiment in the face of a market that has barely moved, we have a new all-time low to report. It took place in the ProShares Trust Ultra VIX Short-Term Futures ETF (UVXY) on Tuesday.

What's UVXY, you ask? Well, it's the 2x leveraged tracking version of the iPath S&P 500 VIX Short Term Futures ETN (VXX). It's a bit less popular than the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), which also tracks 2x VXX. The difference in the two is that UVXY is an ETF, whereas TVIX is an ETN. The ETF structure tends to work better over time but don't tell TVIX about that just yet, as it's still managed to avoid hitting all-time lows.

OK, TVIX is barely above all-time lows. It hit 6.45 on Jan. 22, but "only" went as low as 6.5 on Tuesday, wahoo!

A leveraged tracking version of VXX is perhaps the worst idea for an investment vehicle ever conceived. Long story short on leveraged trackers: they effectively compound gains and losses, which is great when the underlying vehicle rallies almost every day. Or in the case of an inverse tracker, the underlying declines every day. But if the underlying churns, the tracker will essentially chop its way lower and lower. And if the underlying declines look out below in a big way.

VXX, as we well know, is a terrible "investment" to begin with. Thanks to the upward-sloping CBOE Volatility Index (VIX) term structure and the fact that VIX futures almost always price at a premium to VIX itself, VXX tends to drift over time. It's done relatively well in 2014, as we just noted, but even that "stellar" performance has started to ebb. Still, it's hanging in above its all-time lows of $39.85. The trackers have done worse thanks to the compounding effects of the general churn in VXX.

It's important to note that the churn and the compounding have had an even more stark effect on ETFs/ETNs on the "good" side of VXX. That is, they move in inverse to VXX. The ProShares Short VIX Short-Term Futures ETF (SVXY) and the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) are -1x VXX trackers. Each are about 10% below their all-time highs on Jan. 22, even though VXX is only about 2% off its all-time lows on the same date.

Long story short, none of these products are great to hold. XIV and SVXY work over time because VXX will always decline in the long run. They just won't fully capture the drop in VXX.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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