Equity market volatility spiked in response to Japan’s crisis. That makes volatility-ETF buyers winners, right?
The chart below looks at the last three days of trading (and a bit of today) in the SPDR S&P 500 (NYSEArca: SPY), on the red line. You’ll note that despite some alarming headlines about spreading radioactivity, the hard reality of being a U.S. equity investor during all this chaos has been pretty bland. Despite a 3 percent gap down on Tuesday morning that made many investors gulp, as I write this now, SPY holders are down just 2 percent on the week. Not as good as being up, but still, hardly a “Katie-bar-the-door” scenario.
What is true is that volatility came back to the market in a big way. The gray line on top of this chart is the VIX. We’ve railed about VIX as a measurement of volatility before—I even dedicated most of a webinar to it—but it’s probably worth repeating. In a nutshell, here’s what VIX actually measures in real time:
- It finds the 30-day forward price of the S&P 500 (based on options trading) for the first options contract date that isn’t closer than eight days to expiration.
- It then looks at a wide range of strike prices for two strips of options (puts and calls) and weights the premiums investors are willing to pay at those strike prices.
If you really want to get under the hood, you can look at the detailed math. Enjoy.
The formulas used for both figuring out that forward price and then figuring out which options to look at around that forward price aren’t sacrosanct. In fact, they’ve been designed to be easily understood and and calculated, so as to drive CBOE derivatives. Great academic work has been done debunking and improving both calculations (here’s a sample). But the point is that both are rather subjective calls.
So what does VIX really measure? It measures how much people are willing to pay to buy or sell the S&P 500 at dates ranging from eight days from now to almost 60 days from now, at prices well above and well below the current price of the S&P 500. Theoretically, the more people are willing to pay, the more uncertainty exists in the marketplace about where prices are headed.
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.
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.