The Cash Rules Guide to Volatility Trading
“SHORT $UVXY!” That has been my go-to answer to the inevitable “any trading advice?” or “any stock pick?” questions over the years. I would have to say it’s been quite sound advice since $UVXY has since gone from almost $20 billion in 2011 to $17.00 in mid-2023! Yes, you read that right, twenty billion dollars to seventeen dollars (split adjusted), and the extremely safe odds are it’s even lower by the time you are reading this! Unfortunately, it seems everyone has passed on this trade of a lifetime, and tragically, I have even ignored my own advice, employing less lucrative VIX trading strategies over the years.
It’s not just me screaming “Short this pile of crap!”, even $UVXY’s prospectus states the obvious, "If you hold your $UVXY ETN as a long-term investment, it is likely you will lose all or a substantial portion of your investment". It seems the regulators believe that traders and investors carefully comb through prospectuses before placing trades, otherwise, it seems like they would do a better job of protecting the masses from buying such a toxic instrument. But instead of venting at useless bureaucrats, let me explain more about the VIX and its “glitchy” trading instruments such as $UVXY, and how these regulators' negligence can provide the trading opportunities of a lifetime.
What is the VIX?
I won't get overly technical here, I will keep things fairly simple but encourage everyone to dig deeper into VIX, VIX trading products, and the “vol world” by studying further. There are some great resources available, including Twitter. The volatility trading corner of Twitter is populated by some great minds and sharp traders who are many times willing to share their expertise. I will leave some links at the end.
Let me start by defining what the VIX is. The VIX index “calculates the expected price fluctuations in the S&P 500 Index over the next 30 days”. The VIX index uses options to measure the expected volatility, movement, or one might say “the fear” associated with the market. The higher the VIX index, the more volatility is expected. I will also note that the VIX index typically moves inversely to the broad market indices.
Every active investor or trader should familiarize themselves with the VIX and its mechanics, not only because of the opportunities available for trading VIX products but also because the VIX can be a great forecasting tool. For shrewd investors, a low VIX index indicates portfolio protection is on sale, while an elevated VIX might mean it’s time to look for some beat-down bargains. For traders like myself, a spike in the VIX typically provides ripe pickings. Yeah, that's right, while most investors are rightfully fearful of panic, we thrive off volatility and the carnage it brings. We are volatility junkies; the funeral parlor owners, or the ambulance chasers of the financial world.
How to trade the VIX
It is impossible to trade the actual VIX index, you can only trade futures, options, and ETN’s (exchange-traded notes) that “track” the VIX index. Most of the trading in VIX products is done through these ETN’s. $UVXY is the most heavily traded of these volatility ETN’s, with this prospectus of theirs stating “that it aims to provide investors with results that correspond to 1.5x the daily performance of the VIX index”. With a historical average annual return of close to -80%, it’s safe to say its aim is off.
These ETN’s try to replicate the VIX by holding VIX futures. $UVXY attempts this replication by managing a hypothetical portfolio of the two nearest monthly expiring VIX futures contracts, but since future contracts expire, $UVXY is constantly rebalancing by selling the nearest month contract and buying the further contract.
Of course, you can also trade these VIX futures directly through the CBOE, and VIX options give traders and investors another avenue to try their hand at trading the VIX.
Contango and Backwardation
So why is $UVXY such a piece of crap? The answer in one word: contango.
Contango is what we call the situation when the VIX futures contracts are trading at a premium to the VIX index. For example, let us say at the beginning of January the VIX index is at 20, the January VIX future is at 22 and the February future is at 24. Hyperthetocially, this means you are paying somewhere between 22 and 24 for your “exposure” to the VIX index which is sitting a 20.
If the VIX index remains at 20 as January passes, the February and March VIX futures will steadily lose value as they converge to 20 because a VIX futures contract at expiration will be equal to the spot price of the VIX index. Since $UVXY tracks the daily percentage change of a mixture of these two contracts that are steadily losing value in this scenario, $UVXY also loses value.
The inverse of contango is backwardation, and this happens when the VIX futures trade at a discount to the VIX index, and typically happens when the VIX index is elevated. During backwardation, assuming the VIX index remains elevated, the VIX futures will gain value over time as they rise to meet the higher VIX index, and as the futures rise, so would the value of $UVXY. As you can tell by looking at the $UVXY chart, backwardation is much rarer than contango.
The VIX Term Structure
Whether the VIX futures are in contango or backwardation to the VIX spot index is only one part of the puzzle. To predict just how fast $UVXY will decay, or accelerate, we need to look at the VIX term structure, or the relationship between the prices of the VIX futures contracts, and the contango or backwardation associated with that. Since the $UVXY is constantly rebalancing between the nearest two months' VIX futures contracts, the price of these contracts in relation to each other makes a huge difference on the price of $UVXY.
For example, Let us say that the VIX index is at 20 at the beginning of January, the January VIX future (monthly futures typically expire mid-month) is trading at 22, and the February future is trading at 24. If the VIX index stays at 20, not only will both of the futures drift down to the spot index over time, but because $UVXY has to rebalance these futures, it will suffer further decay because it is selling the lower-priced January contract and buying more of the higher-priced February contracts, and because these February contracts sit higher above the price of the spot index, they have even more room for decay. If the VIX futures can stay in contango, which they have been known to do for months at a time, this cycle continues, providing a huge headwind and perpetual doom for $UVXY. Here is an example of the VIX futures in contango:
When the VIX futures are in backwardation, we get the opposite effect. For example, if the VIX index is at 30 at the beginning of January, the January VIX future is at 27 and the February is at 25, the futures would have the wind at their back if the VIX index stayed elevated, causing an increase in the price of $UVXY. Here is an example of backwardation:
Another important, and unique quirk I should mention about VIX, is that it reverts to its mean over the long term. Look at this chart below and you will see after every big spike it eventually comes back down, but how long it takes to come back down varies.
How to Profit
My goal is not to hand out strategies, but instead, explain why any trader looking for that ever-elusive “edge” should explore volatility trading–I will leave the heavy-lifting part, building a strategy, up to the reader. I say “heavy-lifting”, but building and formulating a winning strategy can be one of the most rewarding aspects of trading. Creativity plays an important role in this process, and I find it refreshing to use a little creativity in a job that typically punishes the act of thinking too much. Anyway, these links I am providing can do most of the lifting for you, many of the top volatility traders are kind enough to share their knowledge, and in some cases, their strategies.
I have shared one VIX strategy, simply shorting $UVXY, but despite the eye-popping returns, I still don’t recommend blindly shorting $UVXY (or any other volatility product) without first doing your homework. Not only would I suggest first inspecting the VIX futures curve, and knowing the mechanics of effectively executing this trade, which means rebalancing your position, but also knowing the costs associated with this trade. The $UVXY management fee is one cost to consider, but the blogger costs are usually associated with borrowing the shares to short, and interest fees your broker may charge. Most importantly, have some risk parameters!
The chart above shows the pain that an ill-timed, and poorly managed short volatility trade can cause–a 20x loss in a couple of weeks back in early 2020. Having rules when shorting volatility, such as covering your short when the VIX curve slips into backwardation, can prevent most of these huge drawdowns, but there is always a chance that a catastrophic event hits and there is no immediate escape. Hedging your short vol position is one way to mitigate risk–being short the S&P usually provides a nice counterbalance. Again, carefully examine the mechanics of hedging the position before blindly doing it.
Most of the sophisticated and more successful traders of VIX products attack the trading process with a quantitative or systematic approach, carefully building mechanical trading strategies that take advantage of the contango (and occasionally backwardation) in the VIX futures curves. Often these strategies revolve around trading VIX options.
My advice is to find a strategy that fits your personality, your risk tolerance, and most importantly, has an edge. The "quirky" nature (contango, backwardation, and mean reversion) of the volatility trading space makes it an ideal place to look for that strategy; When an ETN goes from $20 billion to $17, that screams "EDGE!" Even if you don’t end up trading volatility, every serious trader should know their volatility basics. I will leave you with one last piece of advice.. SHORT $UVXY! (disclaimer-I’m not offering trading/investment advice)
Here is a list of my favorite VIX resources and Twitter follows:
http://vixcentral.com/ - Go to place for VIX futures data
@SinclairEuan - His books are must read for any serious volatility traders
@RussellRhoads - Has written two great books on volatility trading