Are We at Risk of a Volatility Spiral?

Are VelocityShares Daily Inverse Short-Term ETN (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY) your best bets to fade volatility?

by Adam Warner

Published on Nov 4, 2014 at 9:49 AM
Updated on Apr 20, 2015 at 5:10 PM

Bets against volatility have soared recently. If the only thing to fear is the lack of fear itself, then maybe it's time to worry. This, from Bloomberg:

Securities that usually gain value as the U.S. stock market gets calmer have never been more popular with investors. That concerns strategists at Deutsche Bank AG.

A combination of investor inflows and declining equity volatility has pushed the market value of the VelocityShares Daily Inverse VIX Short-Term ETN to about $1.2 billion and sent the ProShares Short VIX Short-Term Futures ETF (SVXY) to $564 million, data compiled by Bloomberg show. Both reached records last week.

Interest is building in the exchange-traded products as they recover from swoons that erased almost half their share price as markets buckled and the Standard & Poor's 500 Index tumbled earlier this year. That could spell trouble, according to Rocky Fishman, an equity derivatives strategist at Deutsche Bank AG in New York. Another exodus could whipsaw traders and even exacerbate moves in the Chicago Board Options Exchange Volatility Index.

"The size of these short-volatility ETN products have come to be so gigantic," Fishman, who is based in New York, said by phone. "People saw a lot of money being made on it, so there's certainly the mentality out there that you're at a better entry point now. The 'buy-the-dip' mentality is being applied to the product and it shouldn't be."

And, on the surface, he's right. If masses want to bet against volatility and chase past returns, then they will likely misfire on the position, and then run for the hills during the next volatility pop, adding fuel to the very pop they tried to avoid. But alas, there's way more to the volatility asset-class story.

First off, a buy-the-dip mentality in inverse volatility (aka, a sell-the-pop mentality in a volatility explosion) does tend to work. As we note often, volatility tends to mean-revert, so if you have the stomach to fade it, you tend to win on the trade. Just brace yourself for some pain at first. And, I'd suggest using products like the VelocityShares Daily Inverse Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY) to make the trade more bearable. An iPath S&P 500 VIX Short-Term Futures ETN (VXX) or VelocityShares Daily 2x VIX Short-Term ETN (TVIX) short has open-ended losses, whereas an XIV or SVXY buy can go only to zero -- and they really can't actually go to zero. A better way to look at it: it has embedded positive gamma via the tracking structure.

But, most importantly, while XIV and SVXY interest boomed, so did interest in VXX. It set records for absolute and dollar-weighted volume on Oct. 15. And, volume in regular options, CBOE Volatility Index (VIX) options, and VIX futures also surged. This, via the Chicago Board Options Exchange (CBOE):

This month the closing values of the VIX rose from 14.46 on October 6th, to 29.26 on October 16th. Trading of options on the S&P 500 Index (SPX) at CBOE set a new single-day volume record on October 15 as 2.6 million contracts traded, surpassing the previous high of 2,282,029 contracts on June 20, 2013. Also on October 15, trading volume for VIX options was 1,832,732 contracts, a figure that was close to the all-time high. At CBOE Futures Exchange (CFE), trading of VIX futures set consecutive single-day volume records on October 14 and October 15, with 616,906 contracts and 791,638 (estimated) contracts traded, respectively.

Basically, the entire volatility complex boomed and peaked in mid-October, right as VIX topped. Yada yada yada... I wouldn't worry much about VIX interest toppling the market into a volatility spiral any time soon.

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


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