Looking For The Short Volatility Trade After +170% Year-To-Date

Markets have been made historic moves during these first few months of 2020. Here at Trading Volatility we have stayed focused on following the process of our trading systems to get off to an amazing start on the trading year.

Here is the performance of our indicators in 2020, through March 18th, as tracked by a third party (Collective2):

-  VRP+VXX Bias:   +170%

-  VXX Bias:   +238%

Subscribers to these blog posts have known since last September that something like this was coming, as I outlined in "The Once-A-Decade Volatility Trade" post. In that article I wrote

"Your opportunity is to join us now because once the next volatility spike it's too late. Our gains will be made and those without hedges in place will have lost. It's that simple."  

I'm sorry to say that it is now too late for non-subscribers to capture the full extent of this move.

However, there is still an opportunity to capture additional gains on upside from a long volatility trade (via VXX, UVXY, or TVIX) as well as "The Once-A-Decade Short Volatility Trade" which will happen after this current volatility spike runs its course.

In fact, as I've previously written in my Market Crash Protection post, our indicators successfully identify times when the market is strong and it is appropriate to short VXX (or buy an inverse ETF such as SVXY or the much-anticipated SVIX). The short volatility side of the trade is historically where most of our gains come from.

2020 has been a big year on the long volatility side of the trade and I expect it to be just as big on the short volatility side of the trade as we make our way through the Coronavirus (COVID-19) crisis.

These are difficult times and I believe that our automated trading process can be an enormous benefit to anyone who wants to be able to filter out the noise and emotional pitfalls of trading in this market.

As you know, I was not exaggerating when I said we will have the "Once A Decade Volatility Trade" and I am not exaggerating when I say we will have "The Once A Decade Short Volatility Trade."

Join us as a Trading Volatility+ subscriber so this next opportunity doesn't pass you up.

You can view what we offer to subscribers at our Subscribe page. Considering the information you get from our service, our subscription prices are actually ridiculously cheap. And for those who are afraid of commitment, we offer day passes with full access to our site for as little as $4/day.

To learn more visit our Strategy page. You can also view all the trades that our strategies have generated over the years by looking at the spreadsheets on the Results page or links to Collective2. We strive to be as transparent as possible with our service.

Free E-book:

If you'd like to learn more about our how volatility ETFs work you can read our free e-book, Fundamental Concepts and Strategies for Trading Volatility ETPs, which is available for free download. If you are curious about how our Bias forecasts work and why they have been successful in identifying long-term trends under a variety of market conditions, be sure to give this a read. It explains the basic concepts of VIX and VIX futures as well as the main price drivers of various volatility ETPs, including the popular funds VXX, VIXY, SVXY, UVXY, ZIV, and VXZ. I believe that the concepts outlined in the e-book are critical to understand if you're going to trade these products.

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Hypothetical and Simulated Performance DisclaimerThe 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. Hypothetical and 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, VXX, and ZIV as approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET

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.

Have You Become Part of the Buy-and-Hold Equity Herd?

What is your investing game plan?

Has the S&P 500's longest bull market in history, with its 336% gain, finally converted you to become a part of the buy-and-hold equity herd?

Do you think the U.S. equity market is now immune from the carnage we've seen recently in Emerging Markets (MSCI Emerging Market Index is now off 20% from the January highs)? Have you cast aside the idea of a balanced investment portfolio?

You probably don't want to even think about it, but this bull market will not last forever.¹ There will be an equity bear market here in the U.S. Non-diversified investors risk facing losses similar to that of the 2000 dot com bust and the 2008 financial crisis. The trap is that we don't know when. Any perma-bears left are still taking on losses, ineptly sitting in cash, or getting crushed by cryptocurrencies.

I personally like an aggressive Modern Portfolio Theory portfolio with a heavy weighting on equities -- but with one important modification. I like to carve out a small portion of my portfolio and allocate it to process-driven volatility trading which is long volatility at times and short volatility at other times.

This is the concept of including volatility as an asset and there are right and wrong ways to do it.

 - Wrong way #1: Buy-and hold a short volatility ETP.
XIV, which was the short volatility ETP of choice, suffered a catastrophic hit in February 2018 and investors lost hundreds of millions of dollars. Prior to going bust, XIV was the "can't lose" fund that returned over 10x since inception in 2010. Many people lost nearly all of their investment and various professional money managers were fired because they didn't know what they were doing and ignored the trouble signs of the underlying assets (VIX Futures). The calamity was so bad, that some brokers banned the purchase of short volatility ETPs to try to protect the average investor (a bit late for that, don't you think??).

- Wrong way #2: Buy-and-hold a long volatility ETP.
If buy-and-hold of the short side of volatility is wrong, then it must be better to buy-and-hold long volatility ETPs, such as VXX? No. VXX and the 2x leveraged UVXY & TVIX ETPs suffer long term decay thanks largely due to the fact that these funds track VIX Futures that are most often in a state of contango. Without getting technical, it should be sufficient to point out that VXX has gone from over $100,000 (adjusted for multiple reverse splits) to $27 over the course of its lifespan since inception 9 years ago.

- The Right Way #1: Our VRP+VXX Bias indicators.
Our volatility indicators put us in cash, long volatility, or short volatility based on daily measurements of various components within the volatility market in order to provides us with a "flexible" fifth asset (the others being equities, bonds, real estate, and commodities). To take diversification one step further, our volatility trading indicators are comprised of multiple unrelated component indicators. No single indicator is perfect and ours are no exception. When they don't agree on what to do we move our volatility allocation to cash (this by the way, is how we survived the February volatility market imploded).

One really nice aspect of our VRP+VXX Bias algorithms, in addition to being fully automated, is that they get us invested in an asset that is non-correlated with other assets. This is key to good diversification within a portfolio. Why? Because if you are diversifying using an asset that has high correlation to another invested asset, you are diversifying in name only while both assets carry roughly the same performance.

The flip side of the non-correlated asset coin, however, is the fact that there will be times when our indicators lag the market. 2018 has been pitiful so far and this can be frustrating if you are not looking at the big picture. And that is, a properly diversified and properly balanced portfolio will excel long term.

At any given time there will be a lagging asset within a diversified portfolio. Smart investors don't just scrap an asset class after a bad month/year -- they rebalance and focus on their process knowing that the next year is likely to result in an entirely different outcome. Otherwise, the investor is left with a portfolio that carries less diversification, greater risk, and a lower long-term return potential.


Our indicator's performance speaks for itself with actual automated signals and trades tracked by a third party since 2016, Collective2, here:

Looking further back using our modeling, we can see how VRP+VXX Bias ("Trading Volatility 1" performs in a variety of market conditions. By far, the best performing years for our indicators are when strong equity drawdowns occur, as can be seen in the chart below.

Trading Volatility+ subscribers have access to our VRP and VXX Bias indicators, our intraday indicator data, receive emails with preliminary and final change alerts for each of the indicators as well as our daily summaries, and interact with our private community of volatility traders in the forum. If interested, you can learn more about our services on our Subscribe page.

As always, each day's indicator values, buy/sell triggers, trade performance summary, and equity curves are tracked in the spreadsheets linked at the bottom of our Subscribe page. Additional information on our trading strategy and indicators can be found on our Strategy page.


Our indicators are also utilized by a volatility investment fund that is open only to accredited investors. If you think a managed volatility fund might better fit your needs please send a message through the Contact page.


Footnotes:
¹ Smart people like to pretend they know why this bull market will end: the end of fiscal stimulus, rising interest rates, inflation, deflation, stagflation, global recession contagion, too much debt, high P/E ratios, trade wars, etc. No one knows the why or when and the average investor is unlikely to guess the when, and how it plays out, and be able to invest appropriately.

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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. Hypothetical and 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, VXX, and ZIV as approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET

SVXY and UVXY To Be Re-Purposed Feb 28

Another big news item dropped in the volatility ETP world today. This one from ProShares, who is reducing target exposure for SVXY and UVXY.

Effective 2/28/18:

$SVXY will be a -0.5x volatility fund (previously -1x)

$UVXY will be a 1.5x volatility fund (previously 2x)

This is a similar move to what VMIN & VMAX announced earlier Monday. But while VMIN/VMAX kept their exposure at 1x and moved the duration of VIX futures out ~60 days, SVXY is just reducing its daily movement by half.

As I mentioned in my other post today, this is a more sensible way for a short volatility play. My main gripe is that SVXY went all the way down to -0.5x instead of something like -0.75. The reduced daily movement makes SVXY less attractive as the short vol ETP of choice, but it's nice that you can still buy options against it.

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ProShare Capital Management LLC Plans to Reduce Target Exposure On Two ETFs

Bethesda, MD (February 26, 2018) – ProShare Capital Management today announced that the investment objective of two of its ETFs will change effective as of close of business on February 27, 2018.

ProShares Ultra VIX Short-Term Futures ETF (NYSE Arca: UVXY) will change its investment objective to seek results (before fees and expenses) that correspond to one and one-half times (1.5x) the performance of the S&P 500 VIX Short-Term Futures Index ("Index") for a single day. The Fund's investment objective currently is to seek results (before fees and expenses) that correspond to two times (2x) the performance of the Index for a single day. If the Fund were successful in meeting its new objective, on a day the Index rose 1%, the Fund should rise approximately 1.5%, before fees and expenses. Similarly, on a day the Index fell 1%, the Fund should fall approximately 1.5%, before fees and expenses.

ProShares Short VIX Short-Term Futures ETF (NYSE Arca: SVXY) will change its investment objective to seek results (before fees and expenses) that correspond to one-half the inverse (-0.5x) of the Index for a single day. The Fund's investment objective currently is to seek results (before fees and expenses) that correspond to the inverse (-1x) of the Index for a single day. If the Fund were successful in meeting its new objective, on a day the Index fell 1%, the Fund should rise approximately 0.5%, before fees and expenses. Similarly, on a day the Index rose 1%, the Fund should fall approximately 0.5%, before fees and expenses.

Certain regulatory approvals will be required for the Funds to permanently pursue these new investment objectives. In the event that such approvals are not obtained, the Funds will consider other courses of action.

Our 2015 Indicator Performance: +36%

2015 was a difficult year in the investing world. As it turns out, one of the best performing assets last year was cash since most other asset classes lost money.

According to CNBC, 2015 was the hardest year to make money in 78 years. Investment legends struggled with David Einhorn's Greenlight Capital and Bill Ackman's Pershing Square fund both losing 20%, while average hedge fund performance did not breakeven. In the process, 31 hedge funds shut down during 2015.

It is against this backdrop that we highlight our own struggle in 2015: +36% for our primary indicator (the VRP+VXX Bias).

The end results were respectable, but getting there was anything but easy. The second half of the year was fairly stressful and a bit disappointing given that it was +77% in June. The 2015 equity curve for each of our indicators for trading XIV & VXX, along with XIV's performance, is shown in the following graph.

Drawdowns were painful with VXX Bias experiencing a 43% drawdown in August, fully recovering and hitting a new peak of +94% YTD on September 1st, only to be followed by a 40% drawdown in October. VRP+VXX Bias strategy also experienced a 40% drawdown in the second half of the year and was not able to recapture its +77% high from June before year end.

For the more experienced traders these drawdowns were rather unpleasant. For the uninitiated, the drawdowns were probably enough to make them call it quits. But in the end, it was another year of outperforming just about everything by a large margin with only a couple dozen trades.

In order to compare our results to other known volatility strategies I've included Volatility Made Simple's 2015 performance graph for 24 strategies, below.  Only the VIX vs VXV strategy outperformed our VRP+VXX Bias in 2015, but that strategy's long-term performance remains comparatively poor and suffers from inconsistency (57.6% avg annual return, 0.93 Sharpe ratio, and 70.6% max drawdown).

ZIV Bias Indicator
At -2%, ZIV (the medium-term VIX Futures inverse fund) once again outperformed XIV, which came in at -17% for 2015. While the ZIV Bias indicator was successful in its goal of keeping traders in cash and out of August's major drawdown, it faltered a bit during the choppy trading at the very beginning and end of the year. Ultimately, the ZIV Bias indicator underperformed buy-and-hold this year with a -9%.

As always, each day's indicator values, buy/sell triggers, trade performance summary, and equity curves are tracked in the spreadsheets linked at the bottom of our Subscribe page. Additional information on our trading strategy and indicators can be found on our Strategy page.

Trading Volatility+ subscribers have the benefit of seeing our intraday indicator data, receiving emails with preliminary and final change alerts for each of the indicators as well as our daily summaries, and interacting with our private community of volatility traders in the forum. If interested, you can learn more about our services on our Subscribe page.

2016 is already shaping up to be another exciting year for Trading Volatility. We'd love to have you join us in taking on this difficult market!

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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

A Focus On Process Is Critical To A Trader's Long-Term Success

We are now eight months into 2015 and it's time to once again check in on YTD performance. The last three months have been difficult for the market and we saw a great example of why successful traders are process-oriented rather than results-oriented. So before we get to the scoreboard, let's look at the difference between the two.

Traders need data-driven, reliable, observable, and easy-to-follow trading rules in order to set themselves up for success. Talk to any successful professional and you'll get hear the common theme of process-orientation as one of the keys to success. I'll talk more about how this came into play later in this post.

Now, on to the scoreboard.

The S&P 500 and XIV ("short" volatility ETP) have suffered since our May update, with the S&P 500 -4.2% on the year and XIV now -18% through August. VXX ("long" volatility ETP) is in the same ballpark at -15% while ZIV ("short" medium-term volatility ETP) is -8%.

Fortunately we're not part of the buy-and-hold crowd and instead use our custom indicators to trade volatility ETPs on both the long and short sides (learn more about our strategies here).

Our indicators now sit at (year-to-date, through August):

• VRP+VXX Bias: +40%
• VXX Bias: +69%
• VRP: -7%
• ZIV Bias: -2%

Overall, our indicators actually lost ground since their peaks in June after facing some difficult market conditions from late-June to mid-August. The equity curve can be seen below.

While it can be frustrating to watch some of our gains disappear, this is where the process-orientation kicks in. We know that drawdowns happen in volatility trading, and when they do we refer to our flow chart from above.

Did we lose because we adhered to the trading rules?
Or did we lose because we broke the rules?

Even when you adhere to the rules, the "No big deal" attitude is tough to achieve when dealing with losers. This is especially true when they are back-to-back-to-back-to-back and result in multiple monthly losses. But while those short-term losses can feel painful, it's the long term that we care about. The pros continue to focus on the process of trading using proven indicators rather than short-term outcomes.

By looking specifically at monthly returns we can get a feel for how bad the past few months have been. First, the VRP+VXX Bias indicator had two consecutive months in June and July that were almost as bad as any on record, before recovering a bit in August. 

The next chart shows monthly performance for the VXX Bias indicator. Once again, June and July saw two of the worst consecutive months on record, with performance very similar to that of June/July 2011.

August, however, turned in the third best month ever, rewarding those able to keep trades mechanical and process-driven.

For those interested in additional details of the indicators, the daily history of indicator values that have been emailed to subscribers in 2015 can be found in the data sheet links below:

- VXX Bias: 2015

- VRP: 2015

- VRP+VXX Bias: 2015

If you're struggling to meet your investment objectives in this year's difficult market, perhaps we can help. For less than $3 per day we provide subscribers access to all of our VIX data & metrics, our indicators, automated change alerts, and the members' forum. 

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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

Our Indicator Performance: +71% YTD Through May

Inverse volatility ETFs continued their uptrend in May with XIV adding 13.4% during the month, bringing its year-to-date gains up to +45%. Here's a look at XIV's YTD chart:

A 45% gain in the first five months of the year is pretty good, but our indicators are all outperforming the buy-and-hold approach. Here is the performance of our indicators in 2015, through May 29th:
-  VXX Bias:             +69%
-  VRP:                    +60%
-  VRP+VXX Bias:     +71%

The equity curve for each strategy with comparison to XIV is shown in the following graph (the S&P 500 is +2.4% YTD and is not shown):

Trade statistics for each strategy are summarized as follows:

If you're not quite meeting your investment objectives this year perhaps we can help. For less than $3 per day we provide subscribers access to all of our VIX data & metrics, our indicators, automated change alerts, and the members' forum.

For those interested in additional detail, the daily history of indicator values that have been emailed to subscribers in 2015 can be found in the data sheet links below:

- VXX Bias: 2015

- VRP: 2015

- VRP+VXX Bias: 2015

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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

Our Indicator Performance +56% YTD Through April

April was a great month for inverse volatility ETFs and XIV in particular as it gained nearly 16% over the month to settle at +29% YTD. The trend was generally strong and without drama this month although it did give back some gains in the last week. XIV's one-month chart:

Our daily indicators rode this wave of gains throughout the month on only one trade, with the VXX Bias generating an XIV buy signal on 3-20-15 and our VRP indicator signalling a buy for XIV on 4-1-15.

This month's gains added to already impressive year-to-date returns for our indicators. Indicator performance through April:
-  VXX Bias: +51%,
-  VRP: +48%
-  VRP+VXX Bias: 56%.

The equity curves for each strategy with comparison to XIV are shown in the following graph (the S&P 500 is +1.4% YTD and is not shown):

Trade statistics for each strategy are summarized as follows:

For those interested in additional detail, the daily history of indicator values that have been emailed to subscribers in 2015 can be found in the data sheet links below:
- VXX Bias: 2015
- VRP: 2015
- VRP+VXX Bias: 2015


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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

Why (and exactly how much) Your Leveraged ETF Will Underperform

Experienced investors know that owning leveraged ETFs (2x and 3x) leads to decay in the value of the funds. The decay can be so strong that even if you get the direction right you may still end up with a loss. In this post I will quantify the decay on leveraged ETFs to illustrate the dangers of holding these funds.

As a brief bit of background, leveraged ETFs seek to return the 2x or 3x the daily return of the underlying security. Below are some examples:

NUGT: Returns 3x the daily return of Gold Miners ETF (GDX)

DUST: Returns -3x (inverse) the daily return of Gold Miners ETF (GDX)

TNA: Returns 3x the daily return of small cap stocks (IWM)

TZA: Returns -3x (inverse) the daily return of small cap stocks (IWM)

UVXY: Returns 2x the daily return of a blend of 1st and 2nd month VIX futures (VXX)

There is actually a known formula (**fellow math nerds can see the formula at the end of this post) for the return of a leveraged ETF. The critical variables that dictate leveraged ETF performance are:

1) The return of the underlying index (e.g. GDX, VXX, IWM)

2) The actual volatility of the underlying index

3) The amount of leverage (e.g. 1x, 2x, 3x)

4) The duration of the holding period

In quantifying the decay of these 2x and 3x ETFs I will start by mapping out #2, which is the actual volatility of the underlying index.

1) GDX: Actual volatility (HV20) range: 20 - 80

2) VXX: Actual volatility (HV20) range: 20 - 130

3) IWM: Actual volatility (HV20) range: 10 - 40

Using this information we can build tables and graphs to capture the various scenarios for the return of the underlying and compare that to the return of the leveraged ETF. (Note: All scenarios below assume a holding period of 3 months. Holding a fund for less than 3 months will see relatively less decay, while holding longer will experience greater decay.)

The return of the underlying index is listed in the first column while the various volatility rates are listed in the top row. The intersection of the index performance and its volatility rate gives the return of the leveraged ETF.

1) NUGT

For example, if GDX returned 5% over the holding period and had a 20% volatility rate, the return of NUGT would be 12.3%. Another scenario would be a holding period return in GDX of -12.5% and a volatility of 60%. This results in a return of -48.9% in NUGT. Note that cells colored red indicate that the leveraged ETF is underperforming 3x of the underlying index, while green cells are outperforming. It should be clear from the above that under most scenarios except for when actual volatility is low, a 3x fund will underperform.

The scenarios in graph above can be drawn in graph form for better understanding. The horizontal axis marks the return of the underlying index (GDX, IWM, etc) and the vertical axis marks the return of the leveraged ETF.

NUGT & TNA:

Leveraged inverse ETFs (DUST & TZA):

UVXY:

Because UVXY is only a 2x leveraged fund we a need different chart. However as shown above, the actual volatility of VXX is much higher as well which changes other input ranges.

The resulting concept is the same however: the higher the actual volatility of the underlying (VXX), the more UVXY will underperform. 

Consider someone who expect the market to crash while VIX spikes 80% and VXX spikes 60%. If the underlying volatility of VXX is 80% (which is likely to happen during market crash), UVXY only returns 12.7%. If VXX returned 80% but the actual volatility of VXX is 110% (it saw 120% in fall of 2011), the UVXY return is only -2.3%. Obviously UVXY is a very poor hedge to hold for any significant duration. It is really only beneficial for short duration trades if you have impeccable timing.

Here are the UVXY returns in graphical format:

Don't be lured by the potential return of these leveraged ETF products. Unless actual volatility of the underlying index is very low, you're likely to be just another victim of leveraged ETF decay.

_________

** Return (R) for a leveraged ETF is defined by:

Where x is the leverage ratio, σ is the volatility of the index, and T is the time period the investment is held (source Cheng and Madhavan (2009) and Wang (2009))

Link to Recording of Webinar with Bob Lang and Jay Wolberg

I was invited to join Bob Lang (options trading mentor at http://explosiveoptions.net, contributor to http://thestreet.com, and one of Jim Cramer's go-to technical experts on Mad Money) in a webinar yesterday. The recorded video has been posted online for anyone interested.

We had a great conversation, covering a wide variety of topics in 80 minutes. To help you find topics of interest, I've outlined our discussion along with approximate minute marks.

- Show intro (0:00)

- Bob's current market analysis (1:50)

- Into of Jay (10:15)

- Overview of Volatility (13:25)

- Role of actual market volatility in pricing of forward looking volatility (VIX) (17:18)

- What happens during  recent, brief VIX spikes which quickly revert; impact of QE (24:00)

- Common misconceptions of VXX (30:28)

- Reasons for large blocks of VIX calls (36:15)

- Reason why actual volatility may be higher than implied volatility (39:40)

- Reasons for a rising VIX while the market is rising (41.45)

- Likelihood of seeing a VIX in the 90s again (45:00)

- Reasons for current low VIX regime (47:50)

- Recent pattern of buying XIV on dips and likelihood of continuation of this pattern (51:05)

- Letting data guide trading decisions (53:25)

- XIV technical analysis -- importance of 200-day moving average (54:40)

- XIV indicators (57:30)

- Possibility of rally in XIV in today's market & levels to watch for Friday (1:00:10)

- Do VIX levels have influence on whether equities go up or down (1:02:00)

- Preparing for Black Swan events (1:03:45)

- Current decision making for trading XIV in market Friday (1:08:00)

- Signals for start of new rally in XIV (1:10:30)

- Why Thursday's move in XIV was an indicator that VIX was overbid (1:11:45)

- Tour of free resources at http://tradingvolatility.net (1:14:00)


If you are interested in learning more about trading options from a technical expert, check out Bob's website at http://explosiveoptions.net/ and follow him on Twitter at @aztecs99.

Historical Context Of The VIX And VIX Futures Super-Cycle

VIX perked up in July as it rose 65% from a low of 10.32 up to over 17 in early August. This translated to gains of almost 30% in VXX, which tracks the daily movement of first and second month VIX futures.

Looking at our chart showing the past six months of VIX and VIX futures movement (from the VIX Futures Data page) there is a pronounced rise in all VIX futures over the month of July, bringing levels back up to those last seen in March.

Market participants have become accustomed to these VIX spikes and stick to a playbook of shorting volatility as it approaches 20. Recently this strategy has worked well but will it always work?

To help answer that question I've created an Archives page dedicated to historical data of VIX futures, containing a visual representation of VIX futures data over the past eight years to document the most recent VIX super-cycle.

On this page you can see how VIX futures traded from the calm market of 2006 through the chaos of 2008, all the way back to the calm of 2014. To give this data some context I've also added a selection of the more significant news events that have impacted the market. This allows you to see when various events happened and how they impacted the market. Some examples covered are:

• inversion of the bond yield curve in 2006,
• Bear Stearns downgrade & liquidity rumors,
• signing of the $700B financial bailout bill (Emergency Economic Stabilization Act of 2008),
• points when QE1, QE2, and QE3 begin and end,
• events leading up to the Flash Crash,
• Greek voters reject ruling parties in elections to put bailout at risk and possibly leave the Euro.

Some of the more enlightening graphs are:

Feb 2007 - Aug 2007 when mortgage defaults were rising as adjustable rate mortgage payments reset. The effect was a 50% rise in front month VIX futures over four months while in a contango term structure.

... Feb 2010 - Aug 2010 as Greece requested a bailout and fear of contagion spread across Europe.

... and Aug 2012 - Feb 2013 which shows the magic moment when the FOMC unveiled its open-ended QE3 program to place the most recent lid over volatility. 

You can view all of the graphs on the Archives page. If you are a Trading Volatility+ subscriber you get the extra benefit of using interactive graphs for your research. If you are interested in becoming a subscriber you can do so at the Subscribe page.

Trading Around VIX Seasonality

We're now well into the second half of the year and XIV is sitting on a nice little gain of 28% YTD. But considering that the average annual return for XIV over the past two years is 114%, it is actually struggling a bit. So far this year the VXX weekly roll yield has averaged just -1.14% which will keep gains in check as illustrated by our XIV roll yield scatter plot (from my April post about reducing short volatility profit expectations). The current VXX Bias is only slightly negative, indicating a weak downward trend in VXX (weak upward trend for XIV) that is vulnerable to occasional spikes.

Over the past few weeks it increasingly appears as if the bulls may be losing momentum. Perhaps adding to the jitters is a chart of VIX seasonality that is currently making the rounds. I've included a chart below showing the average VIX from 2005-2013 compared to VIX in 2014.

From the chart we can see that July, August, September and October see increases in VIX (on average). While this is somewhat insightful, the chart is distorted fairly heavily by elevated VIX levels during the second halves of 2007, 2008, and 2011. The distortion is so great that even if we look at seasonality of the VIX for every year back to 1990 we still see the same seasonality trends. Yet in many of those years we saw volatility remain flat or decrease in the second half of the year. It is critical to remember that each year is unique and we must trade the data in the environment that we are in rather than trading the average of historical data. We will need to wait for each day to unfold in order to gather objective data about the state of the current market and trade accordingly.

At this time there is no reason to get too aggressive shorting VXX given the small weekly roll yield. Often the best trade when there is a weak or neutral Bias is to wait for a stronger trend to be established and I think that makes a lot of sense here. Taking smaller positions in XIV as long as the VXX Bias is negative would not be a terrible trade but positions really need to be watched in case we start seeing bearish momentum pick up. The line in the sand for XIV appears to be $44.50 (it closed Monday at $44.08). If it can get above that level and hold XIV could see some more gains here soon. 

Objective Signals For Trading VXX, UVXY, and XIV

The market made an impressive run in May with the S&P 500 hitting new all-time highs at 1955.55 and the VIX touching 10.73. With each passing day during this run it seemed there was yet another article claiming that the market is too high or the VIX too low. With actual volatility of the S&P 500 over the past month just 6.42, a VIX in the 10-12 range makes some sense. But rather than speculate on where the VIX should be, the more profitable question is how to trade the volatility ETPs at these levels.

It's dangerous for investors to speculate on where the market will go next without a solid set of objective tools to guide decision making. At Trading Volatility we rely on our proprietary Bias and Spike Risk indicators to provide us with objective information about the likely direction and momentum of volatility ETPs such as VXX, UVXY, TVIX, XIV, SVXY and ZIV.  The daily signals from our indicators make it possible to substantially outperform the market and today I'll provide a closer look at these signals.

VXX Bias Forecast
After the close on each market day our algorithms generate the Bias and Spike Risk forecasts for the following day and publish the data on our Daily Forecast page. We track all of our forecasts and compare the values to the actual movement of VXX, as shown in the graph of our forecasts over the past six months, below.

Here I've highlighted two distinct periods. The first is from Jan 24th to April 28, a three-month period in which the VXX Bias forecast (the blue line, using the left axis) stayed slightly negative with a handful of moves to a positive Bias. This block of forecasts provides us with an indication that there is no real advantage in shorting VXX (or buying the inverse, XIV) given that there is no directional Bias to help us in our trade. While VXX (red line, using the right axis) did see some price spikes during this time, they were short-lived as the Bias failed to remain positive.

Looking at the second period from April 29 to June 11, the VXX Bias was more solidly negative with Bias reading between -1 and -2. These readings told us that the wind was at our back to short VXX (or buy XIV) as VXX fell over 25% during this time. As of the evening of June 11, the VXX Bias jumped back up toward zero remaining just slightly negative, to once again let us know that it is time to be a bit cautious shorting volatility.


VXX Spike Risk Forecast
The VXX Spike Risk forecast provides us with information on the probability of a VXX spike (for our purposes, a "spike" is defined as a move of 7% or more over the next two trading days). As with the VXX Bias, we track our daily Spike Risk forecasts against the percent change of VXX for each day. The graph below captures forecasts vs actuals for the last six months.

We've only seen one period of sustained VXX Spike Risk (blue line, using the left axis) above 50%, which took place in late January/early February when we saw the big upward +30% move in VXX.  Other than that we've only seen a handful of forecasts reaching above 40%. Looking at the recent period from 4/22 to 6/10 you can see a string of low Spike Risk forecasts below 28% and as low as 16%, indicating time to be a bit more aggressive in shorting VXX. This worked out very well as the price of VXX fell on almost every day during this period (red line, using the right axis). For June 12 we saw a Spike Risk of 49% on a day when VXX gained 6.5% intraday, and today's forecast (June 16) was back up to 48%, once again indicating that we need to be more cautious.


The market provides subtle clues for what the it might do next. As you have now seen, we incorporate these clues into our algorithms to generate what we believe are the best indicators available. If you find yourself struggling in this market check us out. To learn more visit our Subscribe page or drop us a line via the Contact page.