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The Beginner’s Guide To Volatility: XIV

Summary We will cover the basics of XIV. How the performance of VIX futures dictates XIV value. Equitable advice for how to trade XIV. Welcome to part two of: The Beginners Guide to Volatility. These articles are built to serve as educational tools for you to gain a proper understanding of volatility ETFs before you invest in them. For part one: The Beginners Guide to Volatility: VXX, click here . In part one, we discussed pro-volatility products that benefit from increasing volatility and are hurt over the long term from the effects of contango. You may be wondering where that money goes. The answer is inverse volatility products. These instruments bet on decreasing volatility and are aided over time by the effects of contango. As the basis for discussion, we will use the most popular (currently by AUM) inverse ETN, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). There is some debate on the ETN vs. ETF factor and which one is ultimately better when compared to the ProShares Short VIX Short-Term Futures ETF (NYSEARCA: SVXY ). If you look at the long-term chart for both XIV and SVXY, they have near identical returns. SVXY does produce a K-1 tax form , which is a pain. SVXY trades options and XIV does not. I personally like options and trading options bypasses the K-1 form because you never own the security (unless you assigned). Options are a different subject, and I have separate articles dedicated to them. If you are looking to simply buy and hold an inverse volatility product for a short period of time, then I would recommend using XIV. Let’s start by looking at the long-term chart of XIV: If you read part one of this series, then you already know how contango negatively affects pro-volatility products. It has the opposite effect on inverse volatility products. Short-term inverse volatility products sell second-month futures contracts and then hold them short for periods of around 30 days, afterwards the contract is purchased and the process repeats itself. See below for a visual: (click to enlarge) As long as futures are in contango, which is when the first month’s (front month) futures contract is cheaper than the second month’s contract, then XIV will profit. The only exception would be if futures rise a rate higher than that of the contango. Another way that XIV profits is from decreasing volatility. See below for another visual: (click to enlarge) Here is a chart of XIV over the same period of time: Common Misconceptions One misconception I see quite frequently is that anytime is a good time to buy these products. They are often touted as the best investments. This is false. The best time to buy these products is during periods of high volatility and when futures are in backwardation. Backwardation is the opposite of contango and will cause a loss of value in XIV over time. Economics should play a large role in your decision to purchase XIV during backwardation. Should economic conditions deteriorate, then you could be looking at steep losses. Since these products have inception dates in 2010 and 2011, respectively, there is a degree of uncertainty with how they will perform during periods of economic recession. We do know how XIV would have performed in 2011 when fears of a double dip recession and global growth fears weighed heavily on U.S. markets. Thanks to back testing, we are able to manufacture pricing data on VIX futures products from 2004 on. See below for the long-term back tested chart of XIV: (click to enlarge) Chart created by Nathan Buehler using historical data from The Intelligent Investor Blog . Only trading dates (Mon-Fri) were used, but Excel automatically includes Saturdays and Sundays in the axis. As you can see from the above chart, there are good times and bad times to invest in XIV. During periods of recession, you should expect XIV to lose around 90%+ of its value. More back testing is available on SVXY here . The other misconception, that goes along with any volatility futures products, is that XIV tracks the VIX. It does not track the VIX. The VIX Index is not investable. XIV tracks the VIX futures and the VIX futures trade independent of the market and level of stock prices. For more information on these misconceptions, please view part one of the series. Backwardation Backwardation is your number one risk for holding XIV over long periods of time. A simple rise and subsequent fall in volatility would make it relatively risk free. However, backwardation permanently removes value from inverse volatility products during these events. See below for a visual: (click to enlarge) Below is a chart of the price action in XIV during the same period of time: Even though futures traded lower on 12/18/14 than they did on 12/10/14, XIV experienced a loss of value of 2.88%. Again, this was due to the permanent value loss caused by contango. During 2008, it wasn’t just higher volatility that crippled XIV, it was the ultra-high level of backwardation that came with it. (click to enlarge) Chart created by Nathan Buehler using historical data from The Intelligent Investor Blog. Only trading dates (Mon-Fri) were used, but Excel automatically includes Saturdays and Sundays in the axis. Is it rigged? Those that trade inverse volatility products seem to have less notion that the vehicles they invest in are flawed or rigged. These complainers will often come out on the pro-volatility side when things aren’t going their way, which is almost all of the time. These same types of complainers should be expected if inverse volatility products also begin to perform poorly. Currently, we are experiencing very low volatility. Historically, this provides the least reward for the risks involved. It is easy to call something rigged when you don’t understand how it works and it performs differently than you want it to. Gambling and volatility trading go hand in hand for some people. If you fully know and understand the game, volatility trading performs exactly as intended. Conclusion Inverse volatility products produce above-average returns during periods of economic growth. However, the risks they carry during periods of economic retraction should be fully understood by the investor. XIV will benefit from the contango that drags on pro-volatility products. Rising volatility and backwardation are conditions that should be monitored closely when evaluating a position in XIV. Current advice We are currently experiencing low volatility in relation to historical norms. See below: Economics and market psychology ultimately drive the VIX. A great series I like to watch is Jeff Millers “Weighing the Week Ahead.” You can view Jeff’s profile here . As we spoke about before, backwardation and spikes in volatility create the best entry points for XIV. Futures are currently far from backwardation, and I would wait for a better risk/reward entry point. Please follow me here on Seeking Alpha for more tips, education, and news about volatility. Keep an eye out for the last article in this series where we look at mid-term futures products. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Feeling Unfulfilled By The Volatility Tease?

Summary Futures touched backwardation a couple times this week. Investors should realize their risk/reward before jumping head first into the shallow end of the pool. Markets appear to be normalizing mid-week. Feeling unfulfilled by the volatility tease? You’re not alone. Monday was the big headline this week with the market going gaga for Greece. By mid-week volatility ETPs had given up some of their gains but remained elevated. In this ultra-low volatility environment investors forget that the historical mean for the VIX is around 17. By simply reverting to the mean, the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) managed to gain an impressive 40%+ at its peak on Tuesday. However, the pundits were out on Monday already saying to short volatility. I would just question the insight behind such as suggestion. Had you waited until Tuesday, you would have had a better opportunity. These types of one day scenarios are really a volatility trader’s best friend. The markets knew this was coming and still overacted. Economic data out of the U.S. continues to be good and if you have followed my past articles, I have always recommended looking to economics to guide your VIX trading. I continue to seek events that cause over 5-10% backwardation as the optimal risk vs. reward scenario. With that being said I did sell a couple UVXY calls on Tuesday. However, I really wanted this to turn into something more but it appears the market has other plans. Every tick the market took higher really just made me more angry. Can we please just get a good freak out already? In this article I will review the basics of UVXY and go over what I am watching for during the next few months. UVXY (click to enlarge) VIX futures did dip into slight backwardation during the week. (click to enlarge) If you are unfamiliar with volatility products, UVXY will gain premium when futures are in backwardation similar to how the ProShares Short VIX Short-Term Futures ETF (NYSEARCA: SVXY ) benefits from contango. For more information on these two terms, click here . UVXY invests in front and second month VIX futures contracts and will rise when futures rise. Ultimately it will lose value over time, which is why my strategy is to wait for a spike and then enter into short positions through options. It had been just shy of five months since backwardation presented itself. Outlook What this spike in volatility should have showed volatility investors is that market complacency is beginning to wear off. Monday was nothing more than a trigger happy reaction to news that had already been expected to happen. Given the positive economic data, I fully expect liftoff of rates in the September Fed meeting. Any slowdown in growth that coincides with rising rates could trigger another knee jerk reaction from the market. Even though we are in the expansion phase of the business cycle, in my opinion this market will tread water and possibly move slightly higher. If you look at the S&P action this year gains have been minimal and so has volatility. This has been despite record margin debt and record share buybacks from companies. Even more concerning to me is that some of these buybacks are built on margin! Companies will eventually have to repay that debt. What will be left to support earnings growth? Earnings growth is the bedrock of stock market appreciation. We will see an increase in EPS from buybacks but the higher stock prices go, the less effective buybacks become. It has been very quiet on the political front for a long time. Certainly there are angry countries out there preparing to go to war or not pay their debts? Although these things are poor for humanity they make for good volatility investment opportunities. Conclusion It was refreshing to finally have a down day in the market and see UVXY spike. However, traders should not instantly jump on these types of scenarios but rather let it play out a little to make sure you are making the right decision. I am looking forward to a much more volatile end of the year. October is the best month for volatility when looking at seasonality. You have the Feds on deck in September. Too bad the government isn’t shutting down this year. That sure was fun and profitable. Eventually the market will have several tragedies coincide with one another and it will make for a more profitable opportunity to short volatility. Those that entered trades this week, best of luck and remember to manage your risk. I am still at 80% in cash just waiting for a better opportunity in the VIX futures market. My retirement portfolio is performing well with my Citi (NYSE: C ) recommendation but suffered from my Micron (NASDAQ: MU ) purchase before earnings. I was able to cut losses after earnings but my performance for the year resembles that of the S&P 500. Sometimes you just need to be able to look back and realize you made mistakes and move on. Going all in on a little spike in volatility may be profitable a couple times but it will eventually come to bite you. Patience is key, especially in this market environment. I understand that you have to take what you can get, but always remember that capital preservation is your number one priority. Best of luck to you in the coming months! I look forward to getting back to volatility analysis. For free real time updates you can follow me here on Seeking Alpha and on Twitter. Often times during these events I only have time to write an Instablog, due to editing times. If you aren’t a real time follower it will not notify you of Instablog posts. Disclosure: I am/we are short UVXY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Only a couple calls short on UVXY

The Current VIX Landscape Deserves Risk Assessments

Futures are only trading slightly above their historical mean. UVXY and SVXY have both proved they are not buy and hold vehicles. Monitoring backwardation levels provides a better read on trading risks. Hello everyone, I hope your new year is off to the right start. A recent run-up in the VIX futures is cause for an update. I have been closely monitoring the VIXs trend over the last several months. Octobers spike was higher than anything we have seen since late 2011 and mid-2012. This is when investors’ fear of a double-dip recession were beginning to fade. The October spike was a combination of a perfect storm of events including the worldwide Ebola scare. The December spike only speaks to reinforce my theory that investors are on edge and leery of global economic weakness spreading over to the United States. The Eurozone has not been healthy for quite some time. Russia’s economy was put into free-fall with falling oil prices and ongoing sanctions. China has been showing slower than normal growth for some time. The million dollar question is whether or not global weakness will affect the United States. For that I do not currently have an answer. I could sit here and make up data to fit any hypothesis but you know that’s not the kind of writer I am. My personal belief is the United States will lead the world to growth over the next several years. This takes into account many factors such as continued low interest rates, a firming housing market, and managing government and personal debt levels. If the above factors change then things could easily go the other way. I like to be optimistic. Back to the VIX. Let’s take a look at my two favorite VIX ETFs: ProShares Ultra VIX Short-Term Futures (NYSEARCA: UVXY ) and ProShares Short VIX Short-Term Futures (NYSEARCA: SVXY ) I would like to point out that I have consistently written about how neither of these vehicles are buy and hold investments. I have, at times, faced push back from SVXY buy and hold investors. However, the above chart speaks for itself that even over longer periods of time, both vehicles carry significant risk. At the end of this article there is a link to how both instruments would have performed in 2008 and 2011. Contango and Backwardation I have moved away from the traditional strategy of simply watching for futures to enter backwardation and reenter contango. I am now more focused on the level of backwardation. The higher the level of backwardation, the more oversold the market is (in my opinion). Here is a look at the longer-term chart: (click to enlarge) During the double dip recession fears of 2011 the VIX futures (front and second month) hit a backwardation percentage of just over 20%. In contrast, the October event produced a 13% level of backwardation. Any event that pushes backwardation levels beyond 5% is significant. My short-term change in strategy: I currently see too much risk in shorting the VIX, even at current elevated levels. Therefore, I will be more closely tracking the percentage of backwardation in the VIX futures. In the higher risk environment, waiting for futures to reenter contango can take much of the reward away. By monitoring the level of backwardation, this gives you a clearer indication of when the pendulum has begun to swing back towards contango. Unless futures are over a 5% level of backwardation, I will be waiting on the sidelines for a better opportunity. I believe much of the current market weakness is related to commodities and not economic weakness in the United States. Lower oil prices, for a prolonged period of time, do have negative consequences for the economy. A predicted recession in Texas, loss of jobs tied to the shale boom, and many smaller oil and gas companies struggling is not the bright shining star that helped pull us out of the recession. Oil will eventually settle into a range higher than where it is currently trading. Saudi Arabia is playing chicken and the U.S. and Canada are already dropping rigs in response. The world cannot afford oil this cheap (oxymoron?). If you are a regular reader you know I focus a lot on wage growth (economic articles). This week provides more data to either disprove or cement indications that we finally have positive wage growth momentum. The market will be closely monitoring these reports. My advice to you: Be aware of the risks involved with volatility. It is historically trading slightly above its mean. This is not a huge spike by any account. Focus on backwardation levels and if futures are in contango wait on the sideline for a better opportunity. Even in 2008 UVXY would have not returned a profit if held for more than one year. For more data please review my article How UVXY and SVXY would have performed in 2008 and 2011. Purchasing SVXY in a period like this also poses significant risk should things turn south. I worry the last several years have created many complacent investors in inverse volatility products. Patience in volatility will pay off. Trust me, I have been in the position of missed opportunities many times. This only leads to irrational decisions and usually a loss of capital. Don’t feel like you’ve missed any opportunity if the VIX dips to 15 by weeks end. Just sit it out and wait for the next wave, just like a surfer. You can always catch the next one, you just have to be ready.