Tag Archives: xiv

How XIV Earns Value (Hint: It’s Not Through Contango)

From 2012 through mid-2014, the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ), an inverse VIX-futures ETN was a very profitable investment. It rose over 900% during that time. Since the end of that period, however, it’s shed over 60% of those gains, returning to 2013 levels. Any trading vehicle that dynamic is risky. Trading it profitably…and even just avoiding large losses…requires a solid understanding of what drives its movements. Unfortunately, however, many retail investors trade XIV and other VIX-futures ETNs like the ProShares Short VIX Short-Term Futures (NYSEARCA: SVXY ), the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ) and the ProShares Ultra VIX Short-Term Futures (NYSEARCA: UVXY ), based on an explanation of their value changes that’s inaccurate. The prevailing ( but incorrect! ) wisdom goes like this: ” The inverse volatility products (including XIV and SVXY) profit during contango by buying the cheaper front month, selling the more expensive second month and keeping the difference as profit. Since the term structure is in contango most of the time, this ongoing positive roll yield generates profits for the inverse volatility ETNs and drains value from the forward volatility ETNs VXX and UVXY.” You can find this explanation offered many places, including articles on Seeking Alpha: Before diving into what’s wrong with this explanation, I’d like to establish some background with a quick overview of futures and a description of how the VIX-futures ETNs are structured. I’ll then describe the real reason these ETNs’ value changes and look at why XIV was such a profitable investment from 2012 through mid-2014. I’ll discuss the association between contango/backwardation and profitability in the VIX-futures ETNs, then end with some observations on XIV’s dramatic rise and fall that may provide insight for trading these vehicles. The terms contango and backwardation are used throughout, so let’s explain those right away. When the futures term structure is in contango, the price of the front month future, M1, is lower than the second month, M2. In backwardation, the reverse is true. Figures 1 and 2 below illustrate this. Click to enlarge Figure 1. Contango. Click to enlarge Figure 2. Backwardation. Futures Overview Quick disclaimer here: I’m not a futures trader. What I know about the mechanics of this market comes from reading and from analyzing and trading VIX-futures ETNs. A long position on a future is a contract to buy a commodity, a bale of cotton for example, on a certain future date at a certain price — the purchase (i.e., contract) price at which the future was obtained. If market price for that commodity remains low until that contract’s delivery date, the purchaser pays for the benefit of having locked down the price ahead of time. The contract’s seller, on the other side, has the short position and collects a holding fee for storing the commodity and for guaranteeing its price in advance. Using futures, both buyer and seller can establish pricing guarantees for their respective businesses. At first, it may seem the benefit is all on the side of the seller, however, things can go wrong for the seller. Suppose the seller’s warehouse is destroyed in a fire or hurricane, or workers go on strike. If the contract to deliver is for a time far in the future, the seller may not obtain the commodity until after having agreed to its selling price. In all cases, the seller is essentially placing a bet on being able to obtain and/or store the commodity at a low enough price prior to the delivery date to generate a profit. In other words, the buyer is paying the seller to assume a risk on the future price and availability of a commodity. Since both short (seller) and long (buyer) positions can be bought and sold on a futures exchange, these contracts create opportunity for speculators to buy and sell futures without ever getting involved in the physical delivery of the commodity. The VIX futures have a slight twist in that the VIX itself plays the role of physical commodity and the value of the VIX is its spot price. Delivery is purely electronic. Instead of a bale of cotton appearing on the delivery date, the buyer receives (or pays) the difference between the VIX and the final settlement price of the future; the short position’s account pays (or receives) the negative of that amount. In other words, to fulfill the contract at expiry, the seller “buys” a purely numeric value (the VIX) at its spot “price” and delivers that difference to the account that holds the long position. This is equivalent to what would happen in a physical delivery contract if, instead of delivering the physical commodity from a warehouse, the buyer and seller settled in cash for the difference between the contract price and the current spot price. One last point: futures are settled daily. At the end of each trading day, the exchange establishes a settlement price — usually based on the last few trades. All contract positions — short and long — are settled daily by crediting or debiting the difference between the prior contract price and that day’s settlement price. This is equivalent to starting each trading day with a new contract that has the prior day’s settle as its contract price. Design of the VIX-Futures ETNs The VIX-futures ETNs XIV, SVXY, VXX and UVXY, represent a mixture of M1 and M2 contracts. This mixture is rebalanced daily to maintain the equivalent of synthetic future contracts with an expiration date that’s always one month in the future. This rebalancing progressively weights M2 higher and M1 lower until, when M1 expires, all contracts have been moved (rolled) to what was M2 on the day it becomes the new M1 (since the old one has just expired). This daily roll from M1 to M2 to maintain a constant one month expiration date appears to be the source of much confusion. It should be clear from the previous section that profit and loss occurs via the nightly settlement. The daily roll occurs after that profit or loss has already accrued and does not, in itself, change the ETN’s value any more than trading two fives for a ten changes one’s cash total. Sources of Profit and Loss in the VIX-Futures ETNs The daily change in ETN value that occurs via the nightly settlement is the one-day change in contract price of M1 multiplied by the number of M1 contracts plus the one-day change in contract price of M2 multiplied by the number of M2 contracts on that day. To see what might influence these price changes, consider what the VIX futures prices represent. For volatility futures, there’s no storage cost, because the commodity is virtual. It’s a measurement produced, published and maintained by the CBOE. That means the difference between these futures and spot VIX represent the current risk premium to hedge against a rise in VIX prior to the future’s expiry. Buyers are transferring that risk to sellers and sellers charge that premium for carrying that risk. This difference in value, which is constantly being readjusted as market conditions change, represents the current premium longs need to pay to induce short positions — it’s the going market cost of volatility insurance. If the VIX subsequently spikes up above the contract price and remains high, the risk premium may have been an inadequate compensation and the inverse ETN’s value declines to reflect that loss. Conversely, for buyers, their hedge paid off, sheltering them from at least some market downside. If the VIX remains low, however, sellers pocket the risk premium as profit. Contango, Backwardation and the Mythical “Roll Yield” One reason the conventional (but incorrect) wisdom summarized at the start of this article seems so plausible is that it appears to be supported by evidence. XIV and SVXY do indeed tend to go up during periods of contango and down during periods of backwardation, while VXX and UVXY move inversely. Let’s look more closely at that association. When the term structure is in contango, a positive risk premium is in effect. This is the normal state of affairs because without that premium, sellers would have no inducement to de-risk the chance of volatility spikes for the buyers of these contracts. If contango were not the normal state of affairs, there would be no market. Contango is the result , not the cause, of the ongoing risk premium that’s required to make the market in volatility futures. When the VIX spikes above the values of both M1 and M2, the term structure shifts into backwardation. M1 (and usually M2) contracts rise in price to reflect the higher estimate of future VIX based on this spike, but typically remain below spot, since prior VIX (which was lower before the spike), is also factored into the market’s estimate of future VIX. The inverse-VIX ETNs lose value when this happens, while volatility hedges represented by the long side of these contracts pay off. Backwardation is not the cause of these valuation changes; it’s only their visible manifestation. Contango and backwardation are thus lagging indicators. They show what’s already happened, not what’s about to happen. The “roll yield” that’s so commonly described as a profit-loss mechanism in the volatility ETNs simply doesn’t exist. As described previously, profit and loss happen during settlement and are due to changes in the prices of both M1 and M2 as the forward estimate of future VIX adjusts to changing market conditions. The rebalancing, or roll, happens after this valuation change. Where did the misconception regarding a roll-yield profit/loss come from? The confusion may have arisen because the term “roll yield” is commonly used in futures trading — but with a different meaning. It’s used in the context of buying (or selling) a future, letting it expire, then buying (rolling into) a new future with the same duration. That’s different from how VIX-futures ETNs work. And even in the strategy of rolling an expiring future, the term roll yield is just a bookkeeping convenience. The past profit or loss from an expired contract is not changed by subsequently opening a new contract. Each new contract is an independent bet (or hedge) on the future value of VIX. Its net profit or loss still comes from paying or receiving a risk premium and from the difference between past-estimated and future-realized values of the VIX. The Spectacular Rise and Fall of XIV If it’s not due to contango and it’s not due to roll yield, why did XIV rise so vigorously from 2012 through mid 2014? Take a look at the chart in Figure 3, where this period of steady rise on plots of both the VIX and XIV is highlighted. The period of steadily rising XIV is notable for exactly corresponding to the period in which the VIX declined steadily and relatively smoothly to its lowest point since the 2009 crisis. After mid 2014, the VIX began ratcheting back up — slowly at first, then more aggressively, in an upward trend that started in the latter half of 2015. After spiking in August 2015, the VIX failed to return to its earlier lows. This is the point at which XIV finally breaks down. In between mid 2014 and mid 2015, both XIV and the VIX became much more volatile than before. Although XIV put in a new high during that time, once the upward trend in the VIX took hold, XIV began its precipitous fall. Figure 3. XIV and the VIX (aligned). Closing Remarks In summary: There is no yield from rolling VIX futures and contango does not determine profitability for the VIX-futures ETNs. It seems almost too obvious, yet the bottom line here is that changes in the market’s expectation for the future value of the VIX are what matter for the VIX-futures ETNs. Those expectations can be altered by changes in the trend and behavior of the VIX itself. This was a long discussion. I hope it shed light on how these volatility products work and their drivers for profit and loss. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV, VXX, OR UVXY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

A Fork In The Road For XIV

Summary Investors are currently torn between fear mongering pundits and semi-positive economics. An update on the contango and backwardation strategy. The longest period of backwardation in over four years has ended, for now. It has been a very interesting couple of weeks in regards to contango and backwardation. Unlike most of my readers, I don’t get the real time view of the market since I am in the classroom all day. I get a few minutes to check at lunch and that sums up my daily view of the market until around 8pm. My preferred strategy here to profit from the increased volatility has been the contango and backwardation strategy. You can find a detailed description of that strategy, with back testing, here . I always find it fun to go back and read my past writings. When I first started writing for Seeking Alpha, I really wasn’t that great. I believe I had to edit my first article around five times before they agreed to publish it. That is life. Pick yourself up and try again. When I first introduced this strategy on Seeking Alpha, I pointed out that it would not win 100% of the time. Because we are using contango and backwardation as entry and exit points, the strategy becomes difficult when you have futures that consistently bouncing into and out of backwardation. There are two basic options to overcome this problem: Continue on with the strategy. Remember that this strategy will historically protect you from severe losses. Move away from the strategy by holding your position. If you have a long-term positive view for the market and the economy, then you may want to buy and hold a short position in volatility rather than continuing to trade into and out of positions. Before entering these trades you should be fully aware of your potential risks verses the reward. Moving Forward I have stated this previously and it is now being confirmed in the markets. The VIX Index and VIX Futures have moved away from their historically low range. In the short-term I would expect futures to begin trading more towards the historical mean. Take a look at the chart below: (click to enlarge) The VIX will move through cycles of higher and lower ranges of volatility. Historically when the VIX trades in the 10-13 range for an extended period of time, it is followed by a prolonged period where the median VIX will move to a 17-25 range. In periods of economic distress or turmoil that range can be much higher. Let’s look at the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) as a basis for discussion here. We know that XIV is driven by the first and second month’s contract within the VIX futures. If the front month’s contract were to fall to 13 from here, that would represent a theoretical gain of around 30% considering all factors. However, if the front month contract were to fall to 17 than XIV would experience a theoretical gain of around 12%. In both cases you would have the added benefit of contango to compound your gains over time. This would make your actual gain larger than what I am reporting for illustration purposes. Over the long-term XIV needs healthy levels of contango to build value and cannot just depend on falling futures contracts. When assessing risk and reward you need to factor in a potential sea change in the median level of the VIX futures. As you can see below XIV is only off about 17% from six months ago despite experiencing a severe haircut. All of this is can be attributed to the wealth built from contango. See below: We have just experienced the longest period of backwardation in over four years: (click to enlarge) Other events that could affect XIV and volatility The Senate and House are currently debating the next potential government shutdown which is scheduled for the end of this month. This would provide a healthy dose of volatility and negatively impact XIV. The larger question here is, is this now how the United States government operates now? I have written past articles, which have been mainly brushed to the side, on government debt levels. I believe our debt is unsustainable with current levels of economic growth. Ultra low rates have helped our interest payments. I would be more optimistic about our government debt if we had respectable politicians who could put their personal agendas aside and come together to actually solve problems. Much of what I see is theater and kicking the can down the road. For example, the current solution to the government shutdown is to pass a measure to get us to December. Slow growth is now the new normal. This has been confirmed by The Fed and recently several CEOs have come on record as stating the same. The concern with slow economic growth and low inflation is that it doesn’t take much to turn the tide the other way. These are larger economic problems that require us to come together and create solutions that last longer than two months. Conclusion For now, the days of ultra-low volatility are gone but not forgotten. Like the business cycle it will always come back around. Whether that will be in a couple months or several years remains to be seen. I remain optimistic on the U.S. economy and hope that Washington has the will power to create long-term optimism through compromise. We need to help foster genuine sustainable growth. Bubbles create great opportunities for us volatility traders, but hurt real people. We may get into a longer period of contango this week that would again align your trading with the contango and backwardation strategy. However, if the market remains choppy we could be moving between the two often. You will have to make a personal decision on how you want to proceed with your investments. Follow me here on Seeking Alpha for regular volatility updates and news you can use. As always, feel free to leave your professional comments below. We always create some great discussions. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV over 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. Additional disclosure: The author reserves the right to trade into and out of any products mentioned here and generally will not post exact positions or trades in real time. The author does not give individual buy/sell advice.

Is XIV The Place To Be If Markets Stabilize And Volatility Declines?

Summary This large ETN is close to its year low and has lost 43% over the past year. As a play on a quiet fall market, is there money to be made when the VIX goes lower? We do an analysis of this heavily traded ETN and answer these questions and more. The VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) is a rather simplistic (on the surface) security to take advantage of a fall in volatility. According to the sponsor, VelocityShares, The ETNs are medium-term notes of Credit Suisse AG (“Credit Suisse”), the return on which is linked to the performance of either the S&P 500 VIX Short-Term Futures™ Index ER or the S&P 500 VIX Mid-Term Futures™ Index ER (each such index, an “Index” and collectively the “Indices”) The ETNs do have a maturity date of December 04, 2030 but for all intents of purposes the maturity only represents a future date for the instrument to be redeemed or perhaps extended. The ETNs pay no interest and there may or may not be a return of principal upon maturity. A majority of investors in this ETF use the vehicle to hedge against lower volatility. The turnover of only 2 days is indicative of this factor. We will analyze the basic structure and provide some of the key risk factors of this instrument that has seen a significant inflow of funds over the past month. A recent overall structure was quite simplistic: XIV Structure, as of September 10 Contract name Weight CBOE Short-term VIX Future Sept 2015 17.00% CBOE Short-term VIX Future Oct 2015 83.00% As noted, with only 17.00% of the futures contract focused on September, the balance now shifted to October one has an opportunity to participate in lower volatility. The underlying question is, is it that simple? Simply by waiting five days we find it is hardly that simple. Here is the revised structure five days later: XIV Structure, as of September 15 Contract Name Weight CBOE Short-term VIX Future Oct 2015 100% The October contract closed at 23.85 on September 10 and at 20.425 on September 15. All contracts from September have now been rolled over to the current month. As many analysts have stated simply the way VIX contracts are priced, investors will gain approximately 5.00% or more a month on the roll-over. This sounds fantastic and would appear to be a simple way to pick up a very nice return. There are multiple issues why this is not that easy or simple. Since this ETF functions as an inverse to the S&P 500 VIX and is really a short vehicle for the VIX in an ETN form the fund managers in Switzerland via their model and the prospectus must buy contracts that are about to expire and sell the next month. This would be defined as a contango strategy. As such, as noted, XIV may very well gain 5% or more per month simply by rolling future contracts (buying back the ones that are about to expire and sell the next month. The ETN must maintain a short position and bias at all times. The only problem is that not only will the fund lose money during market corrections but also when markets move sideways. These sideway moves occur during political gridlock, holiday periods, Federal Reserve indecision, economic malaise, and during electoral seasons, (in general) to name a few. One of the other problems is that the daily indicative value may be higher or lower than the closing price. As such, an investor can go to sleep believing they could not possibly lose money since the market is rallying overseas, while in fact they lose $.50 per share upon market opening. Fortunately, the share price over time has outperformed the indicative prices and the NAV. Presently the indicative price is $28.08 versus a closing price of $27.75 on September 15, according to Velocity Shares. The one month premium average to the NAV or indicative price has been .78%, reflecting the recent market correction. Many times, (including the presently) it trades at a discount. In terms of the market correction, here are some historical prices and percentage changes on XIV and since August 01 (using XIV closing prices and VIX settlement prices): Date XIV Price C hange Percentage Change VIX Futures Prices Sept/ Oct Change Percentage Change Aug 03, 2015 $48.76 NA NA 15.125 15.875 NA NA Sept 01, 2015 $22.01 -$26.75 -54.86% 29.725 25.825 14.60 9.95 96.52% 62.67% Sept 15, 2015 $27.75 -$21.01 $5.74 -43.08% 26.07% 22.575 20.425 7.45/-6.97 4.55/-5.40 49.25%/-23.46% 28.66%/-20.90% Note: The second numbers listed under change and percentage change are intermediate price changes, (since September 01). As noted above XIV has recouped 26.07% since September 01 and is climbing quickly as global markets settle down and rally, but is still down 43.08% since August 03. The October VIX has lost 20.90% since September 01, yet is still up 28.66% from August 01. Unfortunately, one cannot simply device a model or formula to determine the profit (or loss) potential when the VIX rallies or sells off versus the performance of the XIV. The best we can do is state a 1.24-1.50% correlation between the two. In other words when the VIX rallies an investor should loss approximately $1.25 for every dollar in XIV and when it falls gain approximately $1.50. This is not an exact mathematical formula but simply based upon our own correlation analysis. There are simply too many variables that influence the price action for this correlation to be valid over a significant period of time and further analysis is necessary. Investors should also be aware that the ETN has a net expense ratio of 1.35% versus a category average of 1.27%. In addition, the beta of the ETN is -.90 and the Alpha is -1.7 for the past three years. This is obviously almost a total negative correlation to the S&P 500, but not 100% or a perfect -1.00. A recent article in Barrons stated traders have shunned the ETN this month. Investors placed $345.00M in the ETN in late August, while have only put in $18.9M since September 03. The ETN presently has 1.48BLN market capitalization. The Barrons’ writer should have analyzed further why this is so. One way is to review the holdings of the ETN. Yes, many trader’s use this vehicle as a speculative tool. Predominately, there are large funds and institutions that have placed substantial funds in the ETN as a hedge vehicle for their pension and other large institutional investors. For example, Lazard Capital has a particular fondness or appetite for the vehicle, owning 72,250 shares or 1.76% in one of their Institutional Funds. In addition, Credit Suisse (NYSE: CS ) holds a 26.453% stake, UBS (NYSE: UBS ) 6.46%, and Citigroup (NYSE: C ) holds 3.42%, among other firms. Overall, institutions own approximately 74.04%, with mutual funds hold only .49%, according to Fidelity.com. As such, these institutions are not so much traders as they are hedgers. These investors are simply holding at this time and not adding to their position or selling. They have already placed their hedge for the next quarter. As such, they are using it as a vehicle for their overall holdings to take advantage of lower volatility and add “alpha,” without having to directly go to the futures market. In addition, there are many hedge funds that are using the vehicle to take advantage of a decline in volatility going forward. As a retail investor we feel that an investor may participate with the institutions but only with a portion of assets and on a strictly month to month basis. This is our primary reason in analyzed this ETF since August 01. Since the beginning of the year XIV is down 12.05%, but -44.61% since June 24 when it hit a price of $50.10. It is fruitless as a retail investor to use this ETN as a long term investment vehicle. A quarter to quarter investment or hedging tool to take advantage of calming markets and lower volatility is fine. Unfortunately, we would not recommend this vehicle as a long term, let alone cyclical type investment vehicle. The risks are simply too high as a buy and hold investment. Take advantage of the higher volatility, pick up a quick return of possibly 10% riding the wave of lower volatility, but don’t overstay the party. 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. Additional disclosure: Additional information and analysis is from velocitysharesetns.com, morningstar.com, fidelity.com, yahoofinance.com, tdameritrade.ca, cboe.com, and our own analysis.