Given that an individual investor has the advantage of patience when investing, isn’t buying something like the VXX at these levels a pretty safe/smart bet? Given a 1-2 year time horizon, I would expect a spike in the VIX at some point just based on the way investors tend to over-react to political events. The only way the VXX doesn’t spike again is if were entering an era of extremely stable global politics and sustained economic prosperity…right?
This seems like easy money so I’m curious what a possible argument against this bet would be?
Many naive investors buy VXX thinking that it tracks VIX. This is not true. VXX buys front month futures and rolls them as they expire. So, if the VIX forward curve is in contango (like now), you lose money on the carry. So, patience does not win.
To illustrate, March 2012 VIX futures closed at 20.35 today. VIX closed at 17.29. So, if you buy the March futures and hold until March 21, you lose 15% on roll if VIX does not change. VXX uses a variation of this methodology, so you will lose money unless volatility spikes in the short term.
There is a real problem with people buying ETFs that are future based (either long/ short or leveraged). While the leveraged ones have additional erosion due to daily rebalancing, all derivative based ETFs expose you to losing money when contract are being rolled each month. Of course, there are some instances where you position is actually advantaged by the commodity curve ( lets say you short oil and contracts for following months are quoted higher - this will actually allow you to short the commodity from a higher price). But overall the main thing is on derivative ETFs you need to have great timing.
is VIX a zero sum game? something tells me it is because volatility in and of itself serves no social purpose…it adds no value to society…that’s why i stay away from it…but the futures argument should be your main deterrent…
Well, implied volatility is not really something that you can “invest” in, since it is a measure of market quotes and not tied to a fundamental asset. So, naturally, this means “buy and hold” strategies don’t make sense for volatility. However, this does not mean that the market for volatility serves no social purpose. Investments like stocks have linear payoffs but utility curves of investors are not linear. Options enable people to achieve payoffs that are in line with their utility. As a result, there is real supply and demand for options of various strikes and maturities. Implied volatility is just a convention used to quote prices of those options.
There’s a big debate about whether volatility itself deserves a risk premium. I tend to think that the spread between implied volatility and historical volatility is effectively a risk premium for those who are shorting volatility (i.e. selling options), although it is a little distorted.
VIX does seem to mean revert in terms of levels, so it may be more like inverse bond yields.
I like ohai’s insight that derivatives help investors match their portfolios to their utility curves to a finer resolution (or more cheaply) than is possible through asset exposure alone. Basically, I see that derivatives have two main risks:
some people just use them for leverage, and don’t think about how/whether they can handle the leverage.
there is often counterparty risk that’s hidden in there, particularly with OTC derivatives, and that risk often appears when it is most hurtful to the derivative holder.
But derivatives are definitely useful things when used intelligently. In general, I don’t like to use a derivative unless there is a strong argument for doing so. These arguments tend to be:
There is no equivalent underlying asset that can express the same view or control the risk similarly.
I need leverage (and additional analysis shows that the leverage is not excessive for the portfolio)
Transaction costs are lower than to express the same view with the underlying. (frequently the case for short-horizon trades)
Implied volatility premium over historical volatility is an interesting thing. On one hand, implied volatility premium clearly reflects risk tolerance; OTM puts have higher implied volatility than OTM calls, since people are willing to pay more for protection than bullish bets. However, (as I think you are saying) you could also make a statistical argument that implied volatility can spike to 100 and destroy people who are short volatility. Therefore, sellers of volatility must be compensated with higher prices for volatility.
In general, I don’t like to compare volatility to “derivatives”. Derivatives are tools that you use to trade volatility, equities, credit, or other kinds of underliers. Implied volatility is a much more fundamental thing. There is a very real market for implied volatility.
Good point. I mentioned derivatives and volatility in the same breath because if you have a view on volatility, you generally have to use derivatives to access them.
ETFs have changed that situation for the retail investor, but are effectively packages of derivatives that a retail investor can trade like a stock.
You did interpret my argument about volatility risk premium right. The riskier side of an option contract can lose more than 100% of premium collected, and even dynamic hedging can fail if correlations and/or volatility changes and you haven’t hedged gamma correctly. There is no incentive for anyone to supply this unless there is some kind of additonal compensation. Most often, this shows up in the bid-ask spread, but over the long term it can be thought of as a risk premium.
There’s been a lot of discussion around volatility as an asset class recently. When you take a 60/40 balanced portfolio and start plugging in an allocation to the VIX from 1-10% you see a significant benefit to holding an allocation up to 10%.
The problem is in practice, as Ohai mentioned, it’s very difficult to implemnt inexpensively. Once you practically apply VIX futures (medium-term futures) into the mix with a balanced portfolio you do significantly reduce risk, but performance also suffers.
But, there are several different ETFs and ETNs that link to VIX futures, all with different term structures, underlying indecies, leverage, long vs short, rolldown exposure, reactivity to volatility, and expenses. Bascially, you need somone that really knows what they’re doing to managing volatility as an asset class.
Currently VIX linked ETFs/ETNs are being used in several global allocation funds and target date retirement funds (those at or near their retirement date). The issue is far from settled, but the majority opinion is it’s an okay insurance policy for a well diversified portfolio. Just don’t try it yourself unless you really know what you’re doing.
I wish I could link to this presentation I’m viewing. It’s something that was presented at a Morgan Stanley conference last year. Good stuff.
@FrankArabia My original thought was that I would buy small amounts of the VXX each month that it stays under $25 and then sell on the spikes. I’m not so worried about my portfolio going down, it just seemed like a relatively simple strategy to profit off of the increasing frequency of periods of high volatility.
Thanks for the advice guys. I don’t know enough about the impact that this negative roll yield will have on this specific investment, I’ll have to look into it more.
last night i glanced over Margin of Safety by Seth…i recommend some of you to take a glance at it too…half of the concerns raised on here are addressed in that piece of work…
Last week I closed a position on XXV that I entered last August. It gave me about 8% I bought it because I figured that eventually things would calm down and I could sell it.
Would be careful especially now as the implied volatility term (1 year vs 3 month) structure is very steep and introduces a terrible negative carry profile that will damage returns. While the markets have gone up there are still many fearful investors trying to hedge their portfolios and are paying a hefty price to do so seemingly.