The Best Volatility Trade of 2015 (In Theory)

The year of churn and frustration, 2015, has almost come to a close. We have six sessions left, most of which figure to be quite slow.

Famous last words, but I still would not anticipate much in the way of volatility. But alas, everybody on TV anticipates higher volatility going forward. I mean, literally everybody.

Since I'm pretty sure that the predictions were all the same for 2015, I wanted to take a quick look back at the year in volatility, with an emphasis on volatility as an asset class.

The CBOE Volatility Index (VIX) -- right here, right now -- is actually down a bit in 2015, but that's mostly a quirk of timing, as it spiked a bit at the end of 2014. Median VIX for 2015 is 15.29, up slightly on the year. So let's call it a modestly positive year for implied volatility. I wouldn't call it a wild ride, though.

That's just implied vol. Realized volatility (RV) measures the actual volatility in the underlying. That has actually trended up a bit, particularly in the latter part of 2015. Ten-day RV on the S&P 500 Index (SPX) started 2015 at around 11, which is historically fairly normal for a low-volatility regime. It spent pretty much the first 7.5 months of 2015 at that level or lower, but then spiked to as high as 42 in the August market melt. It gradually drifted back down again to single digits in the fall, but has started rising again recently, and now sits at 21.  

Throw it all together, and it's safe to say that internal volatility is trending higher, and implied volatility is nudging up as well. So, good year for volatility "assets," right? Or at least, not a terrible one, seeing as how volatility itself wasn't a disaster. We all know that contango and compounding (or lack thereof) are quite unhelpful over time. But you'd think 2015 was good enough for the asset gang. But think again.

Here's a chart of the move in the SPDR S&P 500 ETF Trust (SPY) in 2015 vs. the inverse of VIX, the iPath S&P 500 VIX Short-Term Futures ETN (VXX), and the ProShares Trust Ultra VIX Short-Term Futures ETF (UVXY) (i.e., 2x VXX). That is what happened if you went short any of these (and no, you can't actually go short VIX; it's just there for comparison's sake). I also added the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), which actually does track the inverse of VXX.  

Far and away the best idea in 2015 was going short UVXY. It "earned" 75%! And that was in a decent year for volatility.

XIV is pretty horrendous in its own right, down 19%. It's supposed to capture the inverse of VXX, which sounds like a great idea. The problem is that constant churn can kill a tracker, thanks to compounding. And all those late-year volatility pops served to churn VXX a bit. As you can see on the chart, XIV was actually doing pretty well until August, but has been an absolute disaster ever since.

The moral of the story, as always, is avoid these pups on the long side. Shorting works well, but carries huge risk of getting slammed in a volatility pop. It also isn't always possible -- UVXY, for example, is hard or impossible to borrow. That also means there's interest charges on shorts, which makes those returns above not realistic -- it's more for illustration purposes.

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