Jason MacArthur I June 12, 2017
Volatility strategies have recently sparked in popularity. The VIX, and VIX related products, however, have some unique characteristics that set volatility apart from other asset classes. Therefore, it is crucial to have a good understanding of what volatility is and how volatility products behave to successfully navigate this growing market. This introduction is aimed as a foundation and a starting point for understanding volatility and the VIX.
What is Volatility
Before I dive into the VIX, we must first understand volatility. The tricky part is that you will come across two types of volatility: historical volatility and implied volatility.
Historical volatility, sometimes referred to as “realized volatility”, is simply the standard deviation of historical returns. This could be daily returns for the last 10 days, monthly returns for the last year, yearly returns for the last 10 years, etc. Often times, to make an apples to apples comparison, historical volatility will be stated in annualized terms, regardless of the time period. The thing to note here is that volatility is not linear across time – you cannot simply multiply monthly volatility by 12 to get annualized volatility, for example. Rather, volatility is related to the square root of time – if we wanted to annualize monthly volatility, for example, we must multiply the monthly standard deviation by √12.
As an example: 5% monthly volatility = 17.32% annualized volatility (5% * √12)
Daily Volatility * √252 = annualized volatility (252 being the average number of trading days in a year)
Weekly Volatility * √52= annualized volatility
Monthly Volatility * √12= annualized volatility
Let’s back up a minute and think about what an annualized historic volatility of, say, 17% really means. To keep things simple, recall the so-called 68-95-99 rule. If a stock has an historic annualized volatility of 17%, the 68-95-99 rule tells us that 68% of the time the stock traded in a ±17% range (1 standard deviation), 95% of the time it traded in a ±34% range (2 standard deviations), and a 99% of the time it traded within a ±51% range (3 standard deviations). Let’s keep this in mind as we proceed.
Implied volatility, sometimes referred to as “expected volatility”, is the market's expectation for volatility over some period of time (again, usually stated in annualized terms). Whereas historical volatility is determined from realized historic price movement, implied volatility is observed from options prices, which are determined by market forces. More specifically, implied volatility is inferred from the Black-Scholes option pricing formula (it is the only unknown variable) that tells you how large of a price move the market is pricing into the cost of the option. The higher the implied volatility, the bigger the expected move, and the more expensive the option. Understanding implied volatility is important for understanding the VIX.
What is the VIX
Now that we understand volatility, we can better understand the VIX.
The VIX Index, often referred to as “spot VIX” or just "The VIX", is simply the implied 30-day volatility of S&P 500 options. To calculate 30-day implied volatility of S&P 500 options, a weighted average of implied volatility across a range of puts and calls is taken such that the resulting weighted average represents synthetic 30-day implied volatility (the exact calculation is quite complex, but not necessarily required for a reasonable understanding).
So, what does it mean when the VIX is 17, for example? First, note that this really means 17%, not 17. Second, this means that 30-day implied volatility of S&P 500 options is 17%. Finally, going back to the 68-95-99 rule, it means that the market is pricing in a 68% chance of a 30-day annualized move in the S&P 500 within ±17%. Admittedly, this can sometimes be confusing, so it is often helpful to convert the VIX to a monthly basis to determine how large of a move the market is pricing in over the following month. To do this, simply divide the VIX by √12. So, in this example, the market is pricing in a 68% chance of a move within ±4.91%, a 95% chance of a move within ±9.81%, and a 99% chance of a move within ±14.72%, over the next 30-days. To think about this from the opposite perspective, the market is pricing in a 32% chance that the market will move more than ±4.91%, a 5% chance of a move greater than ±9.81%, and a 1% chance of a move greater than ±14.72%.
Characteristics of the VIX
Now that we understand what the VIX is and how it’s calculated, we can discuss its characteristics.
The VIX has been shown to be a mean-reverting index. What does that mean? When the VIX is higher than average, it’s expected to come down. When the VIX is lower than average, it’s expected to move up. This is arguably the most predictable aspect of volatility, and happens because fear is cyclical. Fear and uncertainty don’t last forever, and neither do periods of calm. When markets are in a state of fear, the particular concern always comes to pass. On the flip side, when markets are calm, there will inevitably be some future event that will bring fear back into the market. This will cause the VIX to mean-revert indefinitely. As you will see below, however, capturing returns from mean-reversion can be difficult.
The VIX is Volatile
Taking a look at a chart of the VIX, you can see that it is highly volatile. In fact, since 1990, the average daily move of the VIX has been roughly six times larger than the average daily move of the S&P 500.
Historically, the VIX has roughly a negative 80% correlation with the S&P 500. So, when the S&P 500 falls, the VIX tends to rise. This is largely driven by the fact that people tend to buy put options to hedge their portfolios when the S&P 500 falls – driving up the cost of options (higher implied volatility), leading to a higher level of the VIX. This is why the VIX is often referred to as the “fear index”.
Volatility Risk Premium (VRP)
While not a direct characteristic of the VIX per se, volatility risk premium is an important concept to understand. Those seeking to offset risk on to others (hedgers) tend to be relatively price insensitive compared to those who are willing to assume that same risk (speculators). This can be seen in the tendency of implied volatility of S&P 500 options to sometimes overestimate future realized volatility, and in the tendency of VIX futures to sometimes overestimate future spot VIX. Theses premiums are often collectively referred to as “Volatility Risk Premiums”, or “VRPs”. In the stock market, hedgers effectively pay speculators VRPs to compensate them for assuming the volatility risk of the S&P 500.
The VIX is a derived value calculated from a range of option prices, therefore, it is not directly investable. In turn, volatility products, namely VIX futures (and ETPs based on VIX futures) and VIX options were created to try to provide exposure to volatility. We’ll explore each type of product below.
Entire books could be written on the various volatility products and their nuances. Here is a quick overview to give you a basic understanding.
While spot VIX is not investable, VIX futures can be bought or sold directly. A VIX futures price represents the market’s expectation for 30-day implied volatility of the S&P 500 on the expiration date of the particular future. For example, the July VIX future is the market’s expectation of what spot VIX (30-day implied volatility) will be on July’s expiration date. There are eight different futures contracts traded at any given time (each one has a different expiration week or month). A graph of the various futures across time is called the “futures curve” or the “term structure”. When the futures curve is upward sloping, it is said to be in contango; when it is downward sloping, it is said to be in backwardation.
When the market is calm, the futures curve tends to be upward sloping and above spot VIX, as there is more uncertainty in the future than in the present (the market is pricing in higher volatility in the future). When there is more uncertainty in the present than in the future, the curve tends to be downward sloping and below spot VIX (the market is pricing in lower volatility in the future). This dynamic, along with the fact that spot VIX is not investable, can make it difficult to capture returns from mean-reversion in spot VIX using VIX futures. In other words, the futures curve usually prices in the expectation of mean-reversion in spot VIX (at least to a degree).
VIX options are used for both hedging and speculating. It’s important to point out that a VIX option is a derivative (an option) of a derivative (a future) of a derivative (the VIX) of a derivative (an S&P 500 option). In turn, it’s no surprise that there are several trip-ups that newer investors may encounter when trading VIX options. First, VIX options are priced off of the corresponding VIX future (a 45-day option corresponds to a 45-day future, for example), not spot VIX. This can make VIX options look mispriced relative to spot VIX. In addition, while VIX options are priced off VIX futures, the option settles into spot VIX (because the VIX future that the option is priced off of settles into spot VIX). Further, because VIX options are priced off of VIX futures, you are often “working against” the futures curve in the same fashion as you are when trying to capture mean-reversion in spot VIX using VIX futures. If you can get past the confusion, however, VIX options may provide a way to trade volatility with defined risk, and asymmetrical return profiles.
Exchange Traded Notes (ETNs) and Exchange Traded Funds (ETFs), collectively referred to as Exchange Traded Products (ETPs), are investment vehicles designed to mimic an underlying index/strategy/commodity, and are structured to trade like stocks. Volatility ETPs are designed to track the VIX. However, because the VIX is not investable, volatility ETPs trade VIX futures to gain exposure to volatility. Arguably, two of the most popular volatility ETPs are VXX (short-term long volatility ETN) and SVXY (short-term short volatility ETF). Understanding how these ETPs are structured is crucial.
VXX (Now VXXB)
Below is a chart of VXX (split adjusted). As you can see, its value has steadily plummeted over time (albeit with large spikes from time to time).
This has to do with how the ETN is structured. VXX holds a combination of the front two monthly VIX futures. The two futures are weighted so that the weighted average represents a synthetic 30-day VIX future. Remember, each futures contract settles into spot VIX, and as each day passes, obviously, each futures contract gets one day closer to expiration. This causes the futures to “pull to spot” as they get closer to expiration (the gap between spot VIX and the futures price must close by expiration). So, when the futures are in contango (as is usually the case), holding all else constant, each day the futures lose value as they get one day closer to spot VIX. In other words, each day VXX goes from representing 30-day volatility to representing 29-day volatility (a weighting adjustment is made at the end of each day to get back to 30-day volatility), and this action of “rolling down” the futures curve by one day, causes a drop in the price of VXX. The returns from the “rolling down” of the futures is sometimes referred to as “roll yield”, however, it’s really a function of the VRP (as VIX futures have a tendency to overestimate future spot VIX to compensate speculators for assuming volatility risk from hedgers). The roll yield tends to be negative (because the VRP tends to be positive), which has caused the long-term decay of VXX.
Below is a chart of SVXY (split adjusted). As you can see, its value has steadily increased over time (albeit with large drawdowns from time to time).
SVXY is structured the opposite way as VXX – instead of being long a synthetic 30-day future, SVXY is short a synthetic 30-day future. However, it is important to note that after the events on February 5, 2018, the sponsor has deleveraged its exposure from -1x to -0.5x of the SPVXSP index. This generally puts the VRP in favor of SVXY, which has caused its long-term rise.
Below is a chart of ZIV. As you can see, its value has steadily increased over time (albeit with large drawdowns from time to time).
ZIV is structured much the same as SVXY, but instead of providing short exposure to the front-end of the VIX futures curve (months 1 – 2), ZIV provides short exposure to the middle part of the VIX futures curve (months 4 – 7). Given that the middle part of the VIX futures curve tends to be less volatile than the front-tend, ZIV tends to be less volatile than SVXY.
Due to the tendency for SVXY to rise over time (or VXX to fall over time), volatility strategies attempting to benefit from this trend have sparked in popularity. However, the most basic approach, an SVXY buy and hold strategy, historically has suffered extreme drawdowns. Further, with the complexities inherent in the VIX products, many strategies fail to successfully navigate volatility in a prudent way. Thus, Invest In Vol was created with the mission of making volatility more investable through education and active management.
Invest In Vol
Invest In Vol treats volatility as an asset class. When included in an overall diversified portfolio, volatility strategies may enhance expected returns and/or lower drawdowns.
One strategy we employ, the ZIV Swing Strategy, seeks to harvest the volatility risk-premium observed in the 4 – 7 month VIX futures. By proactively getting defensive (moving to either long volatility or cash positions) when the volatility-risk-premium does not favor ZIV, the strategy seeks to reduce the risk of large drawdowns. Further, the strategy is fully systematic and long-term in nature. These attributes may help mitigate some of the risks associated with inverse VIX ETPs.
To access the knowledge and experience of our professional traders and gain the diversity of three leading volatility strategists in one managed account - including the ZIV Swing Strategy - please do not hesitate to reach out to us.
Investing involves risk, including the possible loss of principal. Carefully consider the Strategy’s investment objectives, risk factors, charges and expenses before investing. This Strategy is actively managed and there is no guarantee investments selected and strategies employed will achieve the intended results. Strategy is subject to change. Active management may also increase transaction costs. The Strategy is not diversified, and narrowly focused investments may be subject to higher risk.
Past performance does not guarantee future results. This information has been provided by Invest In Vol. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an o er to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The views and opinions expressed are those of the portfolio manager at the time of publication and are subject to change. There is no guarantee that these views will come to pass. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. Investments are subject to change without notice.