Volatility ETFs? Think Twice

March 17, 2011

 

So when you see that gray line-spike yesterday, you can interpret that as options traders suddenly paying up for puts, calls or both, on S&P contracts out in the next two months. That’s useful information, to be sure. And if you’d somehow been able to “buy” the VIX on Monday morning before the open, you’d be up a mystical 29 percent.

But you can’t. What you could buy would be VIX futures—contractual bets on where the VIX will be a month or more from now. Buying a VIX futures contract for a month from now is saying, “I’d like to bet that a month from now options traders will be paying more or less than a certain amount, on average, for S&P options one to two months out on the day my futures contract comes due.”

ETF investors are diluting and disassociating themselves from VIX even further. The most popular VIX ETN, the iPath S&P 500 VIX Short Term Futures ETN (NYSEArca: VXX), tracks a notional position in the first- and second-month VIX futures contracts. If you’re keeping score, that second-month futures contract is in essence saying, “What will options traders pay for exposure in the heat of August?”

You can be forgiven for getting confused, and ETF investors can surely be forgiven for seeing the chart and wondering where the heck their 30 percent, three-day return is. If you were holding VXX on Monday, you did OK this week, making over 8 percent on your investment.

But that’s just a snapshot. If you’ve been holding VXX as some kind of a hedge for your portfolio, you’ve been missing out.

 

Volatility YTD: SPY vs VXX vs VIX

 

Year-to-date, VIX is up 47 percent. And your VXX investment? You’ve lost over 4.5 percent. That’s because futures markets in contango burn up money the way my 11-year-old burns calories. That contango is the result of futures market investors betting things get worse—so they bid up tomorrow and sell today, which always seems more certain. That means you’re constantly selling today on the cheap and buying tomorrow at top dollar.

And along the way, while the S&P went up a few percent, your VXX “hedge” was, at one point, down 25 percent.

That’s a great way to lose money.

 

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