Outright speculation on future volatility is a pretty new phenomenon in financial markets.
The mathematization of derivatives markets made traders realize that they’re primarily making bets on future volatility more so than price, which encouraged Wall Street to create more “pure play” products.
The primary volatility products in US markets are VIX futures/options, and exchange-traded products (ETPs) that mimic a position in VIX futures.
Outright VIX derivatives have been around for over a decade, but only began to see sufficient liquidity since the 2008 financial crisis.
As a result, ETF managers sprawled to create their own volatility derivatives in the form of ETPs that trade similarly to stock. As of today, the two big VIX ETPs are SVXY and VXX.
Before we move on, let’s touch a bit on the VIX and how it works.
The VIX Explained
The VIX is the S&P 500 Volatility Index.
It’s a calculation that indicates what S&P 500 options traders think volatility will be for the next 30 days.
The VIX takes various short-dated S&P options contracts into its calculation and looks at what the price is saying.
When the VIX is at 20, what does that mean? It means that the market’s view on volatility for the next 30-days is 20% annualized. This is computed from options prices. The more expensive options (insurance) becomes, the higher the VIX goes.
The financial media call the VIX the “fear index,” and they get a lot of flack about them from options traders, but for the most part it’s true.
Most of the time, the S&P 500 and the VIX are negatively correlated, meaning the VIX goes up when the S&P goes down. Why? Because markets take the stairs up and the elevator down. And when markets start plunging, people start buying insurance (options) to protect their portfolios.
When everyone buys insurance at once, the price goes up.
Keep in mind that the VIX is just an index. You can’t trade it directly and recreating the exact portfolio of options wouldn’t be practical.
There are VIX futures, VIX options, and VIX ETNs listed which all have pretty liquid markets. You can trade those, but they might change hands at different prices than the actual index.
What is an ETN?
It’s important to note that VXX is not an exchange-traded fund (ETF). It’s an exchange traded note, or ETN.
The difference sounds trivial but it’s actually quite important for these purposes. An ETN is an unsecured debt note issued by the ETN manager, meaning there is credit risk, which regular ETFs do not have.
So just keep in mind that there are external factors which could affect the ETN’s value.
What is SVXY? How Does It Work?
SVXY is an ETF that systematically shorts the front-end of the VIX futures curve, specifically the first two months. The product is managed by ProShares and is structured as an ETF, not an ETN.
If you don’t know what the VIX curve is, I’ll explain.
Futures contracts are agreements to make a transaction at a locked in price at a specified future date.
For example, if I buy the July 20th VIX futures contract, I am agreeing to settle the difference in cash by that date if I’m still the owner of the contract at that date.
If I buy the future at $20 and at expiration it’s $18, I have to give my counterparty, the seller on the transaction, $2.
In the futures markets, there’s several different expiration dates.
If you’re a farmer trying to hedge next season’s crop harvest, it doesn’t make much sense to hedge with next month’s futures contracts. And if you’re a short-term trader, it doesn’t make much sense to hedge with next year’s futures. Hence many expiration dates.
So, the VIX futures curve is just the array of prices for different futures contract expiration dates. Here’s an example, from VIX Central:
So, SVXY is systematically short selling those front two months: July and August.
Specifically, it aims to replicate -0.5x the return of the S&P VIX Short-Term Futures Index. Worth noting here is that SVXY rebalances their positions at the end of each trading day, rolling their front-month positions into second-month, etc.
Because the VIX futures are very frequently in contango, there is roll yield from shorting VIX futures. Roll yield is just realizing profit by closing out a near-term futures contract to open a longer-term contract.
Traders primarily use SVXY to get short volatility exposure.
Short volatility is a carry trade. It’s the type of trade where you’re correct very often and make a little, and wrong seldom but lose a lot. For this reason, most short-term volatility traders prefer short volatility because it just works most of the time.
These products are complex. If you’re going to trade them, spend some time reading the prospectus.
What is VXX? How Does It Work?
VXX is basically the complete opposite of SVXY.
It tracks the same S&P VIX Short-Term Futures Index, but on the long side. So VXX holders are paying out all of that roll yield that SVXY holders collect.
And VXX holders are taking the other side of the bet that SVXY holders are making, except VXX holders lose more because they’re suffering from the negative roll yield.
There is a time and a place for long volatility trades, and if they go right, they can be a year changer.
But the vast majority of the time, they go wrong and you lose slowly. That’s not to dissuade you from trading volatility on the long side, just understand the bet you’re making.
When you buy VXX, you are betting on volatility going up. A bet on instability.
If you lose, your money will slowly decay away. If you win, you’ll win fast and big. Just one look at the chart of VXX shows that this is systematically a bad bet.
There’s plenty of super rich investors who focus solely on long-volatility, but I’m sure few are interested in trading VXX.
As you can see, the split-adjusted price of VXX at issuance is around $410,000 per share. That’s a lot of reverse splits to get where we are today!
On average, VXX moves about half as much as the VIX, making it almost completely the opposite of SVXY.
The product is run by Barclays as an exchange-traded note (ETN), which is technically just a debt note issued by Barclays.
VXX has a notoriously bad reputation because of how much money investors and traders have lost in it over time. So if you’re going to trade it, be sure to read the prospectus and understand how the product is structured.
Volatility trading is a really interesting space full of extremely smart people who think about markets differently than most.
These ETPs, while imperfect, offer investors a way to dip their toe in the water of volatility without blowing up on futures or options.
The great thing about SVXY is that you get to short volatility with a limited loss.