Advantages of VIX Future ETFs over the Futures
This is the 5th story our “Journey to Vol Trading” series that chronicles the evolution of our trading. Keep reading for updates.
In our last article, we designed and implemented two algorithmic trading strategies that were effective in capturing some of the movements in S&P 500 volatility. We did so by uisng at the Weighted Average Price (“WAP”) of the Front Month and Back Month VIX futures at the 30 day time frame, which corresponds with the VIX’s own composition timeframe of 30 day S&P 500 options.
While these two strategies, in their combined form, proved effective in backtesting, the use of the 30 day WAP “mix” of futures poses a challenge. More specifically, it requires constant rotation of some Front Month futures into the Back Month futures, as the Front Month futures move closer to expiry so as to maintain the correct average Days to Expiry of 30 days for the entire futures portfolio. This requires either additional algorithmic programming to automate, or daily manual trading.
Fortunately, the idea of trading the 30 day VIX futures WAP is not new, and has been implemented previously in a much easier form, via an Exchange Traded Product (ETP). The first one was VXX:
VXX: Long Volatility ETN
The first VIX Futures ETP was VXX, which launched in January 2009 and was sponsored by Barclays. Interestingly, it was not actually an ETF in the traditional sense. Instead, it was an Exchange Traded Note (“ETN”) which effectively promised the holder that Barclays would pay, in 10 years time, the value of the note in cash. Before it expired in January 2019, a new ETN launched, called the Series B note, trading under VXXB until merging back into the same ticker, and this is the current version of VXX. Due to the popularity of the ETN and some confusion resulting from its 2019 maturity transition, the new Series B note has a 30 year term and expires in 2048.
The usefulness of VXX is that it simplified the trading of the 30 day WAP VIX Futures by doing all the work of rotating Front into Back Month futures automatically.
Details on VXX and additional disclosures, risks etc are detailed by Barclays here: https://ipathetn.barclays/details.app;instrumentId=341408
When we look at the performance of VXX above, it is clear that it is a poor long term investment. We’ve already addressed this in our discussion of Trade 2 in our 3rd article. However, it does show the same peaks of periods of increasing volatility that we would expect, based on its overall correlation to the LONGVOL index which drove our Trade 2 idea.
VXX vs other Long Volatility ETFs
While VXX is the oldest, there are many other ETFs that follow the same strategy and were launched afterwards. The other two most popular ones are:
VIXY: Another 1x Long Volatility ETF
This is basically for all of our trading purposes the exact same as VXX. It has about 1/3 of the volume of VXX. Like VXX is also has options, but they are more thinly traded. We have to note that VIXY has always operated smoothly, whereas VXX had a very public debacle when Barclays failed to renew its shelf registration, which dislocated the price of VXX from its underlying futures portfolio for several months. Given that Barclays then had to pay a $365 million fine to the SEC, as well as face several shareholder lawsuits, we think it is extremely unlikely they would ever repeat this blunder, so using VXX over VIXY is still preferred.
UVIX: 2x Long Volatility ETF
This is an ETF that works the same as VXX but holds 2x the position in VIX Futures. As a result, its movements are augmented, both to the upside and downside. Most brokers do not allow margin when trading VXX, so for those traders trying to use the most leverage, using UVIX could make sense when a very good Long VIX Futures opportunity arises. However, in our own practice, we find that those are few and far between and don’t merit taking the risks of the additional leverage.
Shorting Volatility Approaches
We discussed VXX first as it’s a fairly intuitive approach to the Long VIX Futures trade. We know from our trading, and even the VXX chart itself, that most of the time we actually want to be Short VIX Futures as they spend the vast majority of their time in contango, slowly eroding value.
Let’s now review the various ways we can approach this trade
Shorting VXX
This is, by far, the best way to short VIX Futures. The ETN hold them long, so taking a short position in the ETN itself automagically creates an effective short position on the futures, with the same benefits of the automatic rolling of futures contracts etc.
The challenge here is that almost every broker has a problem locating VXX shares to short. This is unfortunately because most professional volatility traders do exactly that, and the volume they need takes up any VXX shares offered to be borrowed. Some brokers, and we have to call out TD Ameritrade in particular here, will let you open a Short VXX position, only to tell you the next day that the shares were not located and the position has to be closed. This is of course unacceptable because our strategies do not trade intra-day and will often have long hold periods especially on the Short Volatility side.
Synthetic Short with VXX Options
While shares of VXX are hard to borrow, the option chain is quite liquid. This means it’s quite easy to take the next expiring month of VXX options (usually the most liquid) and create a synthetic short by using At the Money (i.e near the current price of VXX) options:
Looking at the current price of VXX at $10.22, we see the nearest monthly expiring options on 7/9/2024 priced as follows
Buy 1 Strike $10 VXX Put @ $0.14 x $0.15
Sell 1 Strike $10 VXX Call @ @ $0.35 x $0.40
This works generally quite well, due to the liquidity of the VXX options chain we may sometimes see only a $0.01 spread between Bid/Ask (in the case of the $10 Puts), or we can often buy slightly below the Ask and sell slightly above the Bid (in the case of the $10 Calls).
We would expect in this particular case to buy the $10 Put @ $0.15 and sell the $10 Call at $0.36 or $0.37. Let’s just assume we have to sell at the Bid at $0.35. We now hold a synthetic short as follows:
We have effectively shorted at equivalent price of $10.20 ($0.35 credit on the sold Call — $0.15 debit from the bought put + the strike of $10). Given the VXX price of $10.22 this means we have replicated the short VXX position quite well.
However, there are a few challenges.
- If we look at our “cost” of $0.02 it doesn’t seem high but remember that these options expire in 10 days. If we extrapolate over a year of trading, assuming that a 10 days cost will always be $0.02 (i.e 0.2%), our yearly cost will be 0.2% * 36 (number of 10 day periods in a year) = 7.2%. This will generally be equivalent or higher than the Short Borrow Fee. Considering that options carry much higher commissions than just short stock (which is nowadays free at most brokers), the actual cost to open this position will still be higher than simply shorting VXX if we could find the shares to borrow.
- Closing this position creates additional commissions and slippage costs. This can be solved by just buying VXX such that the net delta is 0 at expiration. (i.e if you have 1 Synthetic Short with the options above, you can buy 100 VXX shares to effectively “cancel out” the delta of the options).
- When the position expires, as it often will, you will still be “stuck” with the equivalent short VXX shares, which are likely to be unable to be located. That means you will have to buy to cover those VXX shares, and put on another synthetic short with the next set of options. This incurs additional cost, and additional slippage that would not occur with simply holding a VXX short.
- Most importantly, using options makes it much harder to build an algorithmic trading system that functions automatically. It would require reading options chains, placing inter-spread orders (buying options at the ask and selling at the bid creates very large slippage costs) and then adjusting everything depending on the deltas needed. Of course, this is all doable, but doesn’t make as much sense as simply buying or selling shares of an ETF.
Short Volatility Futures ETFs
Due to the popularity of the Short VIX Futures trade and the challenges of shorting VXX, there was naturally a demand for a -1x VIX Futures ETF that would mirror shorting VXX by simply holding the VIX Futures short in the same way.
Shortly after VXX was launched, another ETF was launched in 2010 that did just that: XIV
It was extremely popular and served the purpose of shorting VIX Futures well, until it imploded in February 2018. The discussion of what happened is a bit too complex to be detailed here, but one of the key issues was that XIV would constantly re-balance its holdings based on VIX Futures prices, even after hours. When a spike in VIX Futures occurred, the ETF’s own rebalancing kept driving the futures higher and higher, eventually driving its own losses such that it wiped out the entirety of its value. This was partly driven by the fact the XIV’s issuer, Credit Suisse, was also the largest shareholder, and actually chose to run for the hills rather than let the ETF “rest” and return to stability the next day. An excellent article explores this in much more detail: https://steadyoptions.com/articles/the-astonishing-story-behind-xiv-debacle-r328/
The XIV meltdown caused panic amongst brokers, who believed that any Short VIX Futures ETF would blow up and destroy the fortunes of their retail traders. However, even our very basic models predicted this rise, because the February 2018 volatility explosion was not that unique, and the VIX Futures were already in backwardation when the meltdown occurred, which is always a sure sign of impending volatility dangers.
For many years, ETF issuers, brokers and custodians were very hesitant to offer anything similar. That is until the original creators of VXX, the team from Barclays, launched their own sets of volatility ETFs, and specifically SVIX.
SVIX: Advantages and Concerns
Launched in March 2022, SVIX attempts to replicate the performance of the SHORTVOL index, and thus employs the same overall -1x VIX Futures strategy as XIV. It is currently our preferred method for the Short Volatility trades. Let’s discuss some important aspects of the ETF
Good (not great) Liquidity: SVIX trades about 500 to 800k shares per day, compared to VXX which trades nearly 8 million. While VXX almost always has spreads of $0.01, SVIX usually has spread of $0.03 to $0.05. While this does create slippage, we find that many times, orders can be filled a bit better than Ask (when buying) or Bid (when selling). Due to the lower volume, most orders are filled by market markers, which makes it especially important to use Limit orders and keep order sizes small. This prevents the MMs from front running larger sized trades.
Rebalancing Intelligently: Unlike XIV which had after hours rebalancing, SVIX does so near the end of the trading day. This prevents it from having to trade VIX Futures in illiquid after hours markets where it would be itself the major driver of prices (like XIV was)
VIX Options Hedge: SVIX is the only Short VIX Futures ETF that holds a long position in near month VIX options at a price representing approximately a 100% move up in the VIX. On first glance, this is a disadvantage, because these options will expire worthless almost all of the time, thus drawing down the ETFs assets. A quick calculation based on SVIX’s option holdings over the last 6 month suggest that the cost will be about 7% per year. This is of course, a huge “fee” in the ETF world. However, there are a few considerations:
- Shorting VXX also carries borrow fees, which, depending on the interest rate environment can approach the 7% “cost” of the VIX options
- If a truly unexpected (news or event driven) VIX spike, the VIX options will rise very quickly in price (actually faster than the VIX futures themselves, due to option gamma) and offset some of the losses from the short VIX futures position. As a result, in a sudden, unexpected spike in the VIX, SVIX will actually lose a lot less value than XIV would have. This all but guarantees that SVIX can never “explode” like XIV
- Ultimately, while shorting VXX would be best, the VIX options that SVIX holds appear to be required by their custodian for risk management. In other words, if they didn’t hold those options, the ETF would not be allowed to exist. Therefore, as much as we hate to lose 7% per year to a hedge that is mostly unnecessary, it is the “price of admission” for the short volatility trade which we already know has the potential to generate returns well in excess of the market itself.
Volatility ETF Trading Summary
After discussing all the options above, and implementing all of trading methods over period of time, we find that ultimately the best and most efficient method is to Buy VXX when our model signals increase in volatility and Buy SVIX when our model signals a decrease. Almost all brokers support these trades without any of the other issues we discucssed, and the entire process can be efficiently automated.
We have now discussed the theory of volatility trading, and the practical methodology of how to trade it. After developing a basic algorithmic trading system, the next step is to take this to the next level. We know that market movements and volatility have complex, but repeating patterns. This is where Machine Learning, which is the science of taking large data to make predictions, has excelled in other disciplines. We will now, in the next article, apply ML to Volatility Trading and describe a system that outperforms our previous basic ratio-based approach. See you soon!
********** As always, we make it very clear that this is not investment advice, none of us are allowed to provide investment advice, this is research work product only and any trading decisions should be made on your own based on your own research and trade ideas **********
The ETF’s that we trade have additional risks and disclosures which are provided by their respective issuers here:
