Bread Vs. Cake Part II

October 22, 2009


The Risk Trade, Going Long Market Volatility

We have been long the stock market’s implied volatility through the iPath S&P 500 VIX Short-Term Futures Exchange Traded Note (NYSEArca: VXX) since July 27, 2009. We originally accumulated a 20 percent position through Aug. 27, 2009. VXX now represents 15 percent of gross portfolio exposure because it has lost -25.4 percent of its value from its cost basis through Oct. 14, 2009.

Here we also review the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEArca: VXZ). VXZ is exposed to a daily rolling long position in the fourth-, fifth-, sixth- and seventh-month VIX futures contracts and reflects the market’s implied volatility. Figure 13 plots simulations that will cause us to sell half of VXX and invest the proceeds in VXZ. This trade will create an equally weighted allocation to VXZ and VXX.

Before and after investing in ETNs designed to track futures contracts, it is necessary to have performance expectations and to monitor your position against simulated futures exposures. Figure 13 reviews performance from July 31, 2009 through Oct. 14, 2009 for VXX and an equally weighted allocation to VXX and to (VXZ), VIX at its spot price (basis) and to two alternative simulations. The first is an equal weight of the two front-month contracts (VIX Futures 1+ 2 Month). The second is an equal weight of the futures contracts that are 1.5 months and 2.5 months out from VIX spot prices (VIX Futures 1.5 + 2.5 Month).

Alternative VIX futures simulations provide us with a lot of information about how to be long equity volatility. It is clear that VXX has under-performed the spot VIX Index by 15.4 percent. It also clear that the VIX Futures 1.5 + 2.5 month simulation bests the returns of VXX by 18.8 percent, while the 1 + 2 month strategy bests the execution of VXX exposures in the iPath note by 10.6 percent.

Our simulation of VXZ + VXX (equally weighted) under-performs spot VIX by only 3.1 percent, while VIX Futures 1.5 +2.5 months beats it by a little more than 6.5 percent. VXZ + VXX outperforms the 1+ 2 month strategy by 1.7 percent.

Figure 7 demonstrates the difficulty of capturing futures returns and basis risk, which is a trader’s deviation in returns from the underlying source of returns that he seeks to capture.



We originally chose to be long the VIX via VXX because we believed that it would be like being short two times (2x) the Russell 2000 when we account for their hedge potentials. We also believed that should panic return to the markets, being long VIX would hedge portfolio losses better than being long the 2x inverse UltraShort Russell 2000 ProShares ETF (NYSEArca: TWM). A 15 percent allocation to VXZ + VXX is a more attractive hedge.

Figure 8 compares VXX to TWM, the inverse Russell 2000 ETF. This comparison from July 31, 2009 through Oct. 12, 2009 was -26.3 percent for VXX and -21.3 percent for TWM since July 31, 2009 (Figure 8). Long VXX has the potential to reduce hedging costs should investor fears remain near recent levels, which since June 1, 2009 have produced spot VIX prices near $23-$26 when investors have been bullish and $33 when bearish.



Up until the past week, VXX was a cheaper hedge than TWM. Spot VIX closed below 23 on Oct. 13, 2009.

We sold half of our VXX position at $44.36 on Oct. 16 after VIX recorded three consecutive daily closes below $23. We employed the proceeds to open a 7.5 percent position in VXZ at $80.45 per share.


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