Professional Volatility Strategies

Six years ago on this blog I wrote "XIV: When A "Sure Thing" Goes Bad, highlighting that the key drivers of Volatility ETPs are 1) the change in price of the relevant VIX futures contracts and 2) the term structure. While XIV no longer exists after last year's blow up, the message is still relevant to XIV's reduced leverage replacement, SVXY. In fact, an alternate title for this post could be "When a "Sure Thing" Goes Bad -- SVXY Edition"

Similar to XIV, SVXY is a fund that can be used as a play when an investor believes that volatility will decline. Although SVXY has only half the leverage that XIV had (-0.5x vs -1x), it can still produce strong gains and losses.

Below is a chart of the price of SVXY calculated as if it had the -0.5x leverage since 2004 (prices prior to the fund's official leverage reduction have been constructed by calculating the index value using 1st and 2nd month VIX futures data).

I've highlighted most of the larger price drops to help illustrate that SVXY is not a buy-and-hold security, even in its reduced leverage form. When the market structure changed in 2007 & 2008, SVXY still lost 70% of its value due to strong backwardation in VIX Futures.

As long-time readers know, the term structure of VIX futures is what drives various VIX funds, including SVXY, VXXB, UVXY, TVIX, VIXY, VIIX, and ZIV.

SVXY performs best in years where there is a strong and persistent contango, the condition where VIX is lower than VIX futures. The best way to measure the degree of contango for these products is to look at the weighted value of first and second month VIX futures as compared to spot VIX. Below is a graph of the weighted VIX futures values to spot VIX over the past 11 years.

The trendline here provides a way to filter out the daily noise and allows us to verify that the years in which SVXY performed the best experienced the largest and most persistent contango. On the flip side, the time frames that SVXY performed badly experienced backwardation and/or a small contango.

The fact that the term structure is such a strong driver of VIX ETPs is why professionals track this data closely. We track VIX Futures data and associated metrics shown on our website and use information from the term structure, price momentum, historical volatility, and the volatility of the VIX as inputs to our automated algorithms for buying and selling. The algorithm values are then used to trigger automated buying and selling of VIX ETPs and are emailed to subscribers. We track this data intraday as well and post it to both our Intraday Indicators page as well as our Daily Forecast page.

Our results (as tracked by a third party) substantially beat the S&P 500 over the long term. A screenshot of the VXX Bias and VRP+VXX Bias since we began tracking them on Collective2 are shown below:


VXX Bias:

VRP+VXX Bias ("Trading Volatility 1"):

Over the long term our approach can do well in both bull and bear markets, as seen in by our hypothetical backtest summary.

Clearly not all years are huge winners but the data shows that the use of the term structure data tends to be extremely valuable. If you are interested in checking out what we offer to subscribers you can view our Subscribe page.

One more note: We made a change to our VRP indicator in January 2019 so that it can now be used as a standalone strategy. As such, I am now having Collective2 track that as well. It can be found under Enhanced VRP.


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Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Backtest results do not account for any costs associated with trade commissions or subscription costs.  Additional performance differences in backtests arise from the methodology of using the 4:00pm ET closing values for SVXY,  VXXB, and ZIV as approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

The Quest To Outperform The Market

Chances are, if you're an active trader in this market you are struggling to make money. In reality it's a tough game, one in which hedge funds and mutual funds constantly underperform the market.  In 2012, 88% of hedge funds and 65% of mutual funds underperformed the S&P 500 benchmark. In 2013, the hedge fund average trailed the S&P 500 for the fifth straight year with a 7.4% return, 23 percentage points below the S&P 500.

Why do so many professionals and individual investors lose money? Because in order to be successful in trading you need both a good plan and the discipline to execute against the plan. Without both of these a trader will fail to make money consistently.

While we can't really help you with the discipline, we can help you with the plan. We focus most on trading two securities, VXX (the "volatility futures fund") and XIV (the "inverse volatility futures fund"), based on the direction of the fund's built-in Bias. The Bias is our proprietary way of measuring the current directional force on the fund and is primarily based on the price structure of VIX futures and the internal mechanisms that the funds use to manage their holdings. As these values change each day we measure and report on the Biases in our Daily Forecasts so that we know both their direction and magnitude.

With that information, we apply the simple strategy of buying XIV when the VXX Bias is negative, or buying VXX when the VXX Bias is positive. Trading in the direction of the Bias is critical since it can impact the price of the fund by as much as 10% per week. Trading in the direction of the Bias allows traders to take advantage of the funds structure and can provide an edge in trading.

Over the past couple years, XIV has become a popular fund to own with annual returns of 142% and 85% in 2012 and 2013, respectively. But this is not a fund to buy and hold since it is prone to 80%+ losses if the Bias reverses (see XIV: When a "Sure Thing" Goes Bad). You can see in the table below that while the average annual return of XIV is 46%*, it experienced several ugly years when there was an unfavorable Bias. Rather than suffer through these losses, XIV can be sold whenever the VXX Bias is positive to help reduce drawdowns. This "Negative VXX Bias" strategy has been shown to substantially outperform XIV in 6 of the past 8 years, with an average excess performance of 48 percentage points (far right column, below).

% Gain / Loss By Year
Year	XIV	"Negative VXX Bias" Strategy	"Positive VXX Bias" Strategy	Excess performance over XIV using "Negative VXX Bias"
2006	73%	60%	-15%	-13%
2007	-51%	-34%	13%	17%
2008	-71%	-8%	128%	63%
2009	103%	116%	-9%	13%
2010	135%	284%	42%	149%
2011	-47%	45%	61%	92%
2012	142%	216%	11%	74%
2013	85%	74%	-30%	-11%
Average	46%	94%	25%	48%

A look at each year's performance of the "Negative VXX Bias" strategy shows that while it is still vulnerable to losses, overall the strategy has done exceedingly well compared to the alternatives. A comparison of the annual returns of XIV vs the "Negative VXX Bias" strategy is better visualized below.

You can get a feel for how the strategy performs on a day-to-day basis by looking at the each of the performance data files (**links located at the bottom of this post). In these files you can view a graph of the daily value of a portfolio employing each strategy. The chart below compares the "Negative VXX Bias" strategy to XIV during 2011. Note the flat blue line which illustrates that XIV was not owned in the "Negative VXX Bias" strategy during the time XIV experienced steep losses because there was a positive VXX Bias.

The performance data files also contain the forecast VXX Bias values, entry and exit points, and gain/loss data including a histogram of trades. Below is a summary of trades each year for the "Negative VXX Bias" strategy.

Number Of Trades Per Year For Negative VXX Bias Strategy
Year	# of Trades	Winners	Losers	Avg Trade Gain/Loss
2006	12	6	6	4.94%
2007	14	5	9	-2.43%
2008	13	7	6	-0.33%
2009	11	6	5	8.05%
2010	7	5	3	23.34%
2011	10	3	7	4.54%
2012	11	5	6	12.51%
2013	15	8	7	4.27%

Given the size of gains & losses I've discussed so far it should be clear that these strategies typically align with traders who have a relatively high tolerance for risk. They are not for everyone and they are certainly not for anyone who does not pay attention to the changing Bias of the funds. However, if you're a trader who has decided that these types of funds are right for you, we would love to provide you with the tools to assist in your analysis and decision making process.

In addition to tracking these Biases on our website, we can also send email alerts to let subscribers know when the VXX Bias has changed direction. To learn more about the services we provide you can check out our Subscribe page, or drop us a line via the Contact page. You can also chat with us on Twitter at @tradevolatility if you like. We're here to help and answer any questions you might have about the world of volatility!


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*Daily prices for VXX and XIV prior to fund inception have been derived from existing VIX futures data. Backtests use each security's 4:00pm ET closing value as an approximated trade price for indicators that require VIX and VIX futures to settle at 4:15pm ET.

**Data files: 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014


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Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Additional performance differences in backtests arise from the methodology of using the 4:00pm ET closing values for XIV, VXX, and ZIV as an approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

Shorting Volatility: Time To Reduce Profit Expectations for 2014

With XIV down 7.6% so far this year after seeing 100%+ annual returns in both 2012 and 2013, many have been asking "Is the short volatility trade dead in 2014?" While my terse answer is "not necessarily," we need to take a closer look at the various aspects of the VIX futures market in order to gain some insight on where VIX ETFs could be headed.

The idea of reduced profit expectations for XIV is actually not new. Although XIV gained 107% in 2013, its gains have slowed to just +36% over the past 12 months. While we've talked about this several times last year (here and here and here), today we'll talk about why and take a look at the current outlook.

VIX Futures
The daily price movement of XIV/SVXY, VXX and UVXY/TVIX are determined by the price of the front two months of VIX futures. In the chart below you can see both front month (M1) and second month (M2) VIX futures over the past 12 months.

Current values of M1 (14.85) and M2 (15.75) are generally in the lower-middle portion of the range. We've seen these M1 & M2 price levels with a similar ~1 point spread before. In fact, M1 and M2 are essentially unchanged from 12 months ago and we've seen the same levels six other times during the past year (4/26, 7/29, 9/16, 10/30, 12/3, and 12/19). On all of these occasions we've seen M1 and M2 continue to fall, providing an average gain for XIV of 9% over the next 1-2 weeks. These gains tend to be short-lived as multi-day volatility spikes have resulted in 15%+ drawdowns in XIV for 5 of the 7 instances (exception were 10/30/13 and 12/3/13). This doesn't mean that the same thing will happen this time around, but it does provide some interesting data points.

We can see these moves reflected in the 1-year chart of XIV, below. While VIX futures are essentially unchanged over the past 12 months, monthly expiring futures and the roll yield continue to provide fuel for gains in XIV, which is +36% over the past 12 months (and VXX is -47%). There's no reason this dance can't continue at this "slower" rate as long as M1 and M2 remain range bound under 20, but periodic drawdowns are likely to continue resulting in choppy trading.

As a relevant side note, 3 month actual volatility in the S&P 500 (HV60) has risen about 1.3 points over the course of the past five months. This often serves as an approximate lower-bounds for VIX, as we can see in the HV-IV chart below (see green circles). This means VIX is less likely to soon push back down into the 11.9/12.3 range we saw late last year.

VXX Roll Yield
In addition to looking at the relative position of front month VIX futures, we need to also look at the headwind/tailwind for the securities that arises from the roll yield. The roll yield is proportional to the difference between the 1st and 2nd month VIX futures. Below I've charted VXX's weekly roll yield (WRY) over the past two years.

You can see how the roll yield for VXX has been much less negative so far this year, providing for less of a headwind for VXX and less of a tailwind for XIV/SVXY. In fact, so far this year the average VXX WRY has been just -0.7% (which is +0.7% for XIV). To put that number in context, below is a table of the average XIV weekly roll yield for each of the past 9 years.

XIV: Average Weekly Roll Yield vs. Annual Return

Year	Avg WRY	Annual Return
2005	1.6%	101%
2006	1.4%	14%
2007	0.6%	-35%
2008	-0.6%	-71%
2009	0.9%	118%
2010	2.1%	144%
2011	0.5%	-46%
2012	2.1%	154%
2013	1.6%	107%
2014	0.7%	-8% (YTD)

The 2014 average WRY is more or less in the middle of the range between the low (-0.6%) and high (+2.1%). So why is this important? Because the return of VIX ETFs is largely dependent on the roll yield. as illustrated by a scatter plot for the above table.

You can largely expect that the return of XIV 2014 will end up somewhere along this line. Think about this chart for another minute. Essentially the trendline is telling us that XIV needs an average WRY of at least 0.5% to have a chance at being positive for the year. Factor in a few 25%+ XIV drawdowns and realistically it needs an average WRY of 1% to really provide some confidence in the trade. With VIX futures already quite compressed along the entire term structure, that 1% WRY will be difficult to maintain unless M1 is able to spend much more time in the 13s. This would imply a VIX down in the 11-12 range -- quite a tall order at the moment.

Outliers on the graph above are the result of either a) major differences of the yearly starting and ending values of M1 (i.e. in 2009 M1 went from 45 to 20), or b) large multi-day volatility spikes that cause major (50%+) drawdowns in XIV (e.g. 2006, 2007, 2011) which are difficult to recover from based on the dynamics of percentages (i.e. it takes a 100% gain to fully recover from a 50% loss). For reference, below is a chart showing the value of front month VIX futures over the past 9 years (note that while M1 is low compared to the recent 5 years, it is still higher than most of 2005 and 2006).

VXX Forecast Review
As I turn to look at our daily VXX Bias Forecasts history, below, you can see why we identify the area between -1 and +1 as a "neutral zone" (highlighted in yellow) which is subject to a certain amount of thrash. These are are times when VXX generally moves sideways and is more susceptible to spikes. After looking at this forecast history it's not much of a surprise to learn that neither VXX (-1.7%) nor XIV (-7.6%) have gone anywhere this year.

Summarizing the current situation for XIV (and VXX/UVXY):

• We've seen a narrow XIV weekly roll yield so far in 2014, but it has been increasing lately to the point where it is back above 1%. If XIV is going to continue to see gains the WRY needs to stay above this level. 
• VIX futures are at the lower end of the range over the past few years. They've been at these levels and can continue lower, but their downside is more limited than the upside at this point, making for a pretty non-ideal time to aggressively short volatility. 
• XIV has the potential to continue to rise as VIX futures roll forward each month. The next expiration date is April 16th.

Volatility Trading Outlook With The S&P 500 At All Time Highs

With the debt ceiling drama behind us the S&P has responded by making new all-time highs, while the VIX has fallen back to levels from Sept 20 and are VIX futures are back in a moderate contango. From the VIX Futures Data page:

Since Oct 18, VIX and VIX futures have been essentially frozen with intraday ranges of only a couple points for VIX and a range of closing values of just 0.38 points. The fact that VIX futures across all months are not declining, but flat (and ever so slightly up in months 3-7), is indication that all may not be well -- especially as the S&P is hitting all time highs. Usually when we see the VIX term structure hold steady like this investors are starting to pick up on some sort of risk on the horizon (see May 10th - 21st), however, no risk seems to be readily apparent at the moment (although I can name several that are on my mind). Maybe this is just a period of consolidation after a swift move down, but it doesn't quite sit right with me.

It is a five week roll period this month, with 17 trading days still left until November futures expire on Nov 20. Assuming we manage to avoid unforeseen drama during this time we should expect Nov futures to converge towards VIX (Nov currently at a 11% premium to VIX), and VIX to fall along with HV20 towards HV60. This will cause VXX to drift lower and SVXY higher, however the entire futures curve is once again rather compressed with limited room to the downside and larger risk to the upside. I see a ceiling for XIV over the next few weeks in the $32-33 area (~$125 for SVXY). For ZIV, $36 looks to be the limit.

With people increasingly predicting new highs and getting greedy I start to get concerned and like to raise cash. No one really knows if we'll go on like this for months or if the rally ends tomorrow, but all good things come to end so it's always good to take profits along the way and raise stops to help manage risk.

Is VIX Expensive Yet?

Today the VIX closed at 16.6 while actual market volatility over the past month (HV20) closed at 8.71, resulting of a volatility risk premium of 90.6% (calculated as (VIX/HV20) -1 ) -- (See VIX Futures Data page).

Traders will often look at what is know as the "volatility risk premium" to determine if VIX is cheap or expensive. The volatility risk premium is essentially a comparison of the VIX (expected volatility over the next 30 days (annualized)) and HV20 (actual market volatility over the past 20 trading days, i.e. the trailing 30 days).

The logic is that the market going forward should typically experience a similar amount of volatility that the market has experienced in the past. However, we typically see a VIX greater than HV20 since sellers of options need to be paid a premium for a certain amount of risk that traders expect in the market. A greater amount of expected volatility will cause the premium to increase.

A simple interpretation of this measure is that VIX is considered "expensive" when it is much greater than HV20, and "cheap" when it is much less than HV20.

While this is a relative measurement, today's volatility risk premium of 90.6% looks pretty expensive. But don't expect to VIX to fall just yet.

First of all, the value is a ratio. As actual market volatility increases (during a large rally or large sell off) the ratio will get smaller (given a steady VIX).

Also, 90.6% isn't too crazy just yet. Below are some points over the past 10 years where the market saw other peaks in the volatility risk premium.

• 2/15/12    151.5%     (VIX 21.14; HV20 8.40)
• 3/5/12:     153.6%     (VIX 18.05; HV20 7.12) 
• 5/18/12:   113.1%     (VIX 25.10; HV20 11.78)
• 9/5/12:     195.2%     (VIX 17.74; HV20 6.01)
• 12/28/12: 128.8%     (VIX 22.72; HV20 9.93)
• 1/31/13:   157.8%     (VIX 14.28; HV20 5.54)
• 4/1/13:       74.6%     (VIX 13.58; HV20 7.78)
• 6/3/13:       62.9%     (VIX 16.28; HV20 9.99)
• 8/9/13:     103.5%     (VIX 13.41 HV20 6.59)

The highest this ratio got before the Aug 2011 selloff was 64.1%, which occurred on 8/1/11 (VIX 23.66; HV20 14.42). After that HV20 then pretty quickly rose to a lofty 50.66 (8/29/11) and the ratio hit -36.3%.

More fun facts: 

• The highest HV20 over the past 10 years was 85.19 (on 11/5/2008).
• The highest VIX to HV20 ratio over the past 10 years was 289% on 12/31/10 (VIX 17.75; HV20 4.57)

Lastly, don't forget that if you trade VIX ETPs, they all track to VIX futures and what matters most is the term structure.

Happy Trading!

Trading VIX Around the Upcoming Debt Ceiling Debate

With another debt ceiling debate looming just around the corner, many volatility traders ask "How do I play this event?"

Well to answer that question I like to first figure out where VIX is trading. Currently:

• VIX sits at 14.42 (currently +9.9% on the day)
• Actual volatility of the S&P 500 over the past  month (HV20) is at 11.50, 
• Actual volatility over the past 3 months (HV60) is 9.58. 

These values tell us that a VIX of 14.42 is actually high given the amount of volatility that the market is actually experiencing -- VIX is at a 25% premium to HV20 and a 50% premium to HV60. The market is already expecting a greater amount of volatility in the next month compared to what we have experienced in the past 3 months.

The recent rise in VIX to 17 in late August was for the most part attributed to the events in Syria. Once was a diplomatic solution was "found" VIX began to retreat to normal levels. As you can see by the green circles in the graph below, VIX tends to fall toward the "floor" set by HV60. With HV60 currently below 10 and VIX at 14.39 there is still a long ways to fall (33%). However, just because the floor is down below 10 doesn't mean that it'll necessarily make it down there.  HV20 is on the rise, moving from 6.49 in early August to above 11 today, an indication that the market as a whole is growing more volatile.

An interesting point in the chart above is 8/30/13 (see red rectangle) when the value of front month VIX futures (M1) was 17.5 and HV20 was 9.58, an 83% premium. It is rare for front month VIX to be above 17 while HV20 is below 10. In fact, in the past nine years this has only happened a handful of times (7/2004, 12/2009, 3/2010, 11-12/2010, 1/2011, 4/2011, 2/2012, 8/2012, 12/2012). In most instances M1 and HV20 converge towards each other over the next 3-6 weeks then rise rapidly together as VIX and actual volatility spike. We'll soon find out if the 8/30/2013 instance follows a similar pattern.

But given that VIX is trading at a premium to actual volatility and VIX futures are in contango, the expectation is that VIX and VIX futures will continue to fall. That means the "correct" long-term play as of now, due to the structure of VIX ETPs, is to continue to short volatility both for near-term VIX futures (long SVXY/XIV or short VXX/TVIX/UVXY) and medium-term VIX futures (ZIV), although I believe that smaller positions are warranted given the compression in the VIX futures curve.

Now that we've taken a look at the technical side, let's get back to the question about the debt ceiling.

We've been through several rounds of debt ceiling political theater weighing on the stock market. After a few rounds of debt ceiling and sequester deadlines in the past 2 years the market seems to be getting used to the sequence of events, complete with a last minute deal to once again kick the can into the future.

One idea of how to play the Sept/Oct 2013 episode is to wait for a VIX spike that occurs in the final hours of negotiation just before the deadline and short volatility. History gives us some positive data that this could be a good play. However, this strategy depends on several points:

1) Will market participants fret enough to cause a rise in VIX in advance of the event?

• In the July 2011 episode VIX ranged between 15 and 21. In Nov/Dec 2012 VIX ranged between 15 and 19.6. After hitting 12.52 last Friday, VIX is now at 14.32 with just one week left for congress to pass a "Continued Resolution" to continue spending after Sept 30th, and several weeks until all extraordinary measures to continue spending have been exhausted by the Treasury. Not only is the market not worried about this, but there's not even the infamous "countdown clocks" on the major media stations. I think you have to assume it will be political grandstanding business as usual and implied volatility will rise over the next several weeks, but it is not clear if this will happen as a gradual build up to the event, or more quickly just as the event is about to occur. Being long VXX over the next few weeks could be difficult given the "headwind" it faces due to the contango term structure. 

2) Will a deal get done?

• I think the answer is yes and I believe the market believes the answer is yes. Whenever this happens, the immediate reaction will most likely be positive and make for a very good short volatility play (assuming there is a build up in VIX leading up to it). 

3) Will a market-positive deal get done?

• Given the ratings downgrade and sell off after the July 2011 episode, this question should be of concern to investors as well. While a deal is likely to get done, investors will be looking at the "cost" of the deal. The details of  the deal, as well as the manner in which it is achieved, are just as important as the deal getting done in the first place. This will remain an unknown until it happens but is something to keep an eye on after the immediate reaction.

 
I prefer to take the information one day at a time to see how this episode plays out, closely watching for any significant changes to the VIX futures term structure and ensuring I have appropriate stops in place. The biases remain positive for SVXY, XIV and ZIV and negative for VXX, TVIX, and UVXY so I like to use those to my advantage while they exist.

Also remember that some periods of trading are easier than others. A directional move is easier to trade and more profitable than a choppy market, and you have to expect that the market over the coming weeks will be choppy and event-driven. There is a good case to be made to avoid this period altogether and wait for the "easy" money to be made once a new direction has been established.

Most Popular Posts: Tools And Resources To Help Simplify Trading Of VIX ETPs

For most people, the concepts of volatility-related ETFs and ETNs are difficult to grasp. If I just state what they are by saying that they track the daily change of values for the expected annual dispersion of the stock market at different at points in time between 1 and 7 months into the future, I don't get many looks of understanding. 

And it's not because people aren't smart. I've had conversations on the topic with people coming from highly intellectual backgrounds including doctors, lawyers, engineers, actuaries, CEOs, CFOs, even financial investment professionals. The most positive response I usually get is a subtle indication that they are still awake while I'm talking.

The fact is that these are complex products engineered by the issuing banks to produce specific results. One could even go so far to argue that some of the securities are designed to be confusing and/or to lose money. For example, VXX has lost 99% of its value since its launch on Jan 30, 2009. TVIX has lost 99.8% of its value since it was launched on 11/30/10. Both of these have undergone multiple reverse splits and TVIX has another 10:1 reverse split planned for Aug 30th.

However, not all VIX futures products decline in value. The securities XIV and SVXY provide the daily inverse of VXX, meaning that if VXX declines by 1% on a given day, the value of XIV and SXVY increase by 1%. 

What many people don't realize is that the performance of these securities are a direct result of how the products are structured. Rather than being a matter of supply and demand, as is the case with stocks, these funds are driven by the values of two or more VIX futures, which creates a bias either for or against their long term value. It would not be surprising to see VXX and TVIX lose another 99% of their value in the coming years should the issuing banks continue to issue reverse splits assuming the underlying structure remains biased against them. 

The whole key then is to identify where the biases exist and then get on the right side of the trade. Trading of these products can be highly profitable if done correctly.

This entire site was created to help people do just that. In addition to providing VIX Futures Data and Daily Forecasts, I have written many blog posts about how VIX ETPs work. Today I'd like to re-share what I think are the absolute must-reads for anyone interested in trading these securities. There's always room to improve so I will continue posts in the future, but in the meantime take a look through the articles below and feel free to reach out to me with any feedback or questions you may have.

• Why VXX is Such a Killer (Five-Months View of VIX Futures Data)
• Secrets of VXX: The Value of the Roll Yield
• The #1 Rule For Trading Volatility ETFs
• XIV: When A "Sure Thing" Goes Bad

VIX Nears A Floor After A Week Of Heavy VIX Selling

VIX took a holiday as well this week falling 11.9% from last Friday's close. The VIX Futures term structure contango steepened as all months along the curve fell in proportion to VIX. Here's the week over week change in term structure:

From our daily forecasts we can see that after a month of elevated spike risk, the VXX Spike Risk forecast fell below the 5.0 "danger zone" on the evening of June 26th and remained there this week, with VXX losing 12% since that time (and XIV +13.3%).

Spot VIX is starting to press down towards the VIX "floor" set by actual market volatility over the past 3 months (HV60), with VIX now just 5% higher than HV60. We could still see VIX press down into the 13s, but I don't expect it to head much lower (see green circles below).

UPDATED 7/8: Corrected week-over-week term structure chart and VIX % change

Reviewing June's VIX ETF Forecasts And A First Look At July

June was a tough month for inverse VIX ETFs such as XIV and ZIV. A relatively flat term structure and somewhat skittish markets led to losses of 10.9% for XIV and 9.3% for ZIV.

Let's take a look at what the Trading Volatility daily forecasts were telling us over the past 5 weeks.

The VXX Spike Risk forecast spent nearly the entire month (from the evening of 5/28 until evening of 6/26) above 6.0, indicating an above average probability of VXX spiking. During this time we saw a rash of days with VXX gains as it rose 18%.

Looking at the chart of the VXX bias forecast vs VXX price we can see that the VXX bias spent most of June in or on the edge of VXX neutral zone (between -1 and +1) which was not enough to offset the rise of the underlying values of the VIX futures.

Similarly, ZIV suffered from the high VXX spike risk and relatively small bias of its own.

Overall, the VIX futures and market dynamics looked a bit like the May-July 2011 timeframe, which saw mostly sideways & choppy action. If we see more of the combination of a neutral VXX bias and high spike risk it will turn into a 2007-type dynamic (flat term structure and rising futures along the whole curve) which could justify VXX long positions, even with a slightly negative VXX bias.

As we look forward to July, we can see from the forecasts above that the VXX spike risk finally dropped below 5.0 on 6/26 and the VXX bias has started to grow more negative. This will create a better environment for XIV and ZIV as long as this forecast trend continues.

About the Trading Volatility Forecasts
The Trading Volatility daily bias forecasts provide important information about the headwind or tailwind of VXX, XIV, and ZIV based on the VIX Futures term structure. Over longer timeframes, a positive bias will help the price of the security to move up while a negative bias help push the security go down.

The Trading Volatility spike risk forecast indicates that the structure of VIX and VIX futures put VXX at risk for moving higher in the next 1-2 days. When this value is above 5.0 I often look for ways to protect my portfolio by reducing exposure to XIV & ZIV and increasing exposure to VXX.

You can read more about Trading Volatility's forecasts here.

You can get access to the current daily forecasts and other VIX futures data by subscribing to Trading Volatility+ for less than $3 a day.

The #1 Rule For Trading Volatility ETFs

Every couple weeks or so I see a new article from someone giving advice on how to trade volatility ETFs & ETNs such as XIV, VXX, SVXU, UVXY, and ZIV. Often the author will at least know that these products trade based on the VIX futures. But every once in awhile I'll see something more misguided, like the chart below. While it looks promising, once it is applied to historical data it does not deliver positive results.

For example, let's take a look at the period between August 2004 and May 2006 when VIX bounced between 10 and 16 (VIX on left axis; VXX on right axis). The chart says buy VXX below a VIX of 16.

The return for VXX during this time was -75%, a loss attributed to the fact that the front two months were in contango with a spread averaging 0.98.

Let's continue on to the next period, between May 2006 and Feb 2007 when VIX was spending much of its time between 10 and 12.  The result for VXX is a 57% loss, and again the reason is a contango term structure, with an average spread between front month futures (M1) and 2nd month futures (M2) of 0.85.

You may point out the spike in VXX from $1000 to $1350 on the left hand of the chart, which is a nice 35% gain. Unfortunately, if you were following the chart and buying XIV when VIX rose above 16 then you would have lost 30% over the next couple of weeks before almost breaking even if you held your position until VIX dropped below 16 again.

OK, so I can hear some of you saying that I'm cutting off the chart before VIX and VXX spikes. Take a look at the next period, from Feb 2007 to Feb 2011 when VIX spiked during the 2008 crash. During this time VIX was above 16. Since the chart above says buy XIV when VIX is above 16, I'll compare VIX (left axis) to the price of XIV (right axis).

The result is a 64% loss up until Dec 2007, followed by another 66% loss from Aug 2008 to Dec 2008, for a total of an 88% loss in XIV from 2/27/07 to 12/19/08.  At this point your position has essentially been demolished after this 21 month period. But let's give you the benefit of the doubt and say that you stayed solvent and held on to this position for the 4 year period until VIX dropped below 16 again. In that case you managed to almost break even in that XIV trade.

Looking at the term structure during this period, we find that between 2/27/07 and the bottom in 12/19/08 the term structure was in backwardation, with an average of a 0.67 spread between the first two months. Backwardation has the effect of making VXX rise and XIV fall.

From 12/20/08 to 3/24/2011, when the price in XIV goes up from 2 to 14 for an excellent 7x return, the term structure is back in contango with an average of 1.51 points between M1 and M2. Contango has the effect of making XIV rise and VXX fall.

At this point, the #1 rule in trading volatility-based ETFs should be clear: Follow The Term Structure.

The term structure is going to be the biggest driver of price for volatility-based ETPs over time. There are of course other factors that need to be taken into account when trading volatility ETPs in order to maximize your gains, but you will be able to trade these products pretty well just by following this rule.

To view the current term structure and other metrics that are critical to trading volatility ETPs, visit the VIX Futures Data page.


**Note: VXX and XIV price data prior to the funds' first trading days (1/30/2009 for VXX and 11/30/2011 for XIV) have been calculated by using the VIX short-term futures underlying index values derived from actual data of month 1 and month 2 futures.