Trading volatility 5/11/2012. Trading volatility. At what cost? TVIX. Copyright (c) 2012 by Robert E. Whaley. All rights reserved.

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1 Trading volatility At what cost? TVIX reserved. 1

2 Trading volatility Outline: VIX futures and options markets Why trade volatility? VIX ETP market Product offerings Transparency Performance Destabilization of VIX futures market At what cost? VIX futures and options markets CBOE started reporting in January VIX derivatives launched more than decade later. VIX futures launched by CBOE Futures Exchange in March 24. VIX futures options launched in February 26. reserved. 2

3 VIX futures and options markets 1,, 9, VIX futures VIX options Average daily trading volume 8, 7, 6, 5, 4, 3, 2, 1, VIX futures and options markets 4, 35, VIX calls VIX puts Average daily trading volume 3, 25, 2, 15, 1, 5, reserved. 3

4 Why trade volatility? Risk management Take directional view on market volatility Fundamental economics analysis Why trade volatility? VIX (%) August 199: Iraq invades Kuwait October 1987: Stock market crash October 1997 and August 1998: DJIA experiences record losses. September 21: Terrorists attack World Trade Center. January 1991: US begins military action in Iraq. October 28: Credit market collapse. April 211: S&P downgrades US credit rating /2/1986 6/25/ /15/1996 6/7/22 11/28/27 reserved. 4

5 Why trade volatility? Risk management Take directional view on market volatility Fundamental economics analysis Statistical analysis: Implied volatility is mean-reverting. Deviation of implied volatility from realized volatility. Hedge volatility exposure Buy calls to hedge tail risk. Diversify. Use collateralized futures position to create new asset class. Why trade volatility? Focus on diversification. Risky asset return/risk parameters S&P5 MSCI VIX MT Expected return 12.% 1.% -4.% Expected volatility 24.4% 23.3% 32.2% Expected correlations S&P MSCI VIX MT Maximize Sharpe ratio. Note negative expected return for MT index. reserved. 5

6 Why trade volatility? Optimal allocation is Final risky asset portfolio Fractional weights Maximum slope.5893 Expected return 7.1% Risk 1.21% 28.74% of portfolio is invested in VIX MT futures volatility index. Expected return 25% 2% 15% 1% 5% % -5% -1% % 5% 1% 15% 2% 25% 3% 35% Volatility Why trade volatility? (Ogilvy station) reserved. 6

7 VIX ETP market Product offerings (March 3, 212) 3 different ETPs 8 most active are: Average Asset value Date of Yearly Benchmark Inst. Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner. VXX ipath S&P 5 VIX Short Term Futures ETN 32,14,131 1, % ST TR 1 3.4% TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344, % ST ER 2 1.% XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739, % ST ER % UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478, % ST ER 2 3.4% VXZ ipath S&P 5 VIX Mid-Term Futures ETN 467, % MT TR 1 38.% VIXY ProShares VIX Short-Term Futures ETF 273, % ST ER % SVXY Proshares Short VIX Short-Term Futures ETF 111, % ST ER -1 5.% VIIX VelocityShares VIX Short-Term ETN 91, % ST ER % About as active as Ford shares VIX ETP market Product offerings (March 3, 212) 3 different ETPs 8 most active are: Average Asset value Date of Yearly Benchmark Inst. Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner. VXX ipath S&P 5 VIX Short Term Futures ETN 32,14,131 1, % ST TR 1 3.4% TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344, % ST ER 2 1.% XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739, % ST ER % UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478, % ST ER 2 3.4% VXZ ipath S&P 5 VIX Mid-Term Futures ETN 467, % MT TR 1 38.% VIXY ProShares VIX Short-Term Futures ETF 273, % ST ER % SVXY Proshares Short VIX Short-Term Futures ETF 111, % ST ER -1 5.% VIIX VelocityShares VIX Short-Term ETN 91, % ST ER % As big as small S&P 5 stock reserved. 7

8 VIX ETP market Product offerings (March 3, 212) 3 different ETPs 8 most active are: Average Asset value Date of Yearly Benchmark Inst. Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner. VXX ipath S&P 5 VIX Short Term Futures ETN 32,14,131 1, % ST TR 1 3.4% TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344, % ST ER 2 1.% XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739, % ST ER % UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478, % ST ER 2 3.4% VXZ ipath S&P 5 VIX Mid-Term Futures ETN 467, % MT TR 1 38.% VIXY ProShares VIX Short-Term Futures ETF 273, % ST ER % SVXY Proshares Short VIX Short-Term Futures ETF 111, % ST ER -1 5.% VIIX VelocityShares VIX Short-Term ETN 91, % ST ER % Management fees VIX ETP market Product offerings (March 3, 212) 3 different ETPs 8 most active are: Average Asset value Date of Yearly Benchmark Inst. Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner. VXX ipath S&P 5 VIX Short Term Futures ETN 32,14,131 1, % ST TR 1 3.4% TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344, % ST ER 2 1.% XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739, % ST ER % UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478, % ST ER 2 3.4% VXZ ipath S&P 5 VIX Mid-Term Futures ETN 467, % MT TR 1 38.% VIXY ProShares VIX Short-Term Futures ETF 273, % ST ER % SVXY Proshares Short VIX Short-Term Futures ETF 111, % ST ER -1 5.% VIIX VelocityShares VIX Short-Term ETN 91, % ST ER % S&P VIX futures indexes used as benchmarks. reserved. 8

9 VIX ETP market Product offerings (March 3, 212) 3 different ETPs 8 most active are: Average Asset value Date of Yearly Benchmark Inst. Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner. VXX ipath S&P 5 VIX Short Term Futures ETN 32,14,131 1, % ST TR 1 3.4% TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344, % ST ER 2 1.% XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739, % ST ER % UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478, % ST ER 2 3.4% VXZ ipath S&P 5 VIX Mid-Term Futures ETN 467, % MT TR 1 38.% VIXY ProShares VIX Short-Term Futures ETF 273, % ST ER % SVXY Proshares Short VIX Short-Term Futures ETF 111, % ST ER -1 5.% VIIX VelocityShares VIX Short-Term ETN 91, % ST ER % Leveraged and inverse products VIX ETP market Product offerings (March 3, 212) 3 different ETPs 8 most active are: Average Asset value Date of Yearly Benchmark Inst. Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner. VXX ipath S&P 5 VIX Short Term Futures ETN 32,14,131 1, % ST TR 1 3.4% TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344, % ST ER 2 1.% XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739, % ST ER % UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478, % ST ER 2 3.4% VXZ ipath S&P 5 VIX Mid-Term Futures ETN 467, % MT TR 1 38.% VIXY ProShares VIX Short-Term Futures ETF 273, % ST ER % SVXY Proshares Short VIX Short-Term Futures ETF 111, % ST ER -1 5.% VIIX VelocityShares VIX Short-Term ETN 91, % ST ER % Institutional ownership reserved. 9

10 VIX ETP market Market value of largest 8 VIX ETPs 4,5 4, Market value in USD millions 3,5 3, 2,5 2, 1,5 1, VIX ETP market: Transparency ETPs should be fair and transparent buy-and-hold investments. Futures and options markets have restricted access. Must sign detailed risk disclosure statements indicating in deep knowledge of risks. Stock markets have low-cost public access and traders are less sophisticated on average. VIX ETPs are complicated VIX futures trading strategies. Should they be allowed to trade as shares of stock? reserved. 1

11 VIX ETP market: Performance How well does VXZ track S&P VIX MT futures index performance? Summary statistics: VXZ SPVXSTR n 773 HPR % % Volatility 31.78% 32.5% Regression: VXZ on SPVXSTR α t(α ) β t(β ) R VXZ S&P VIX MT Less than one basis point. VIX ETP market: Performance How have S&P VIX indexes performed since inception in 25122? VIX ST futures index VIX MT futures index ST ER MT ER n 1,58 1,58 Mean daily return -.12%.17% Standard deviation 3.911% 2.41% Holding period return -93.9% -5.4% Compounded annual growth -36.% -.9% reserved. 11

12 VIX ETP market: Performance Personal favorite is VXX. Recall VXX is highest market cap ETN at $1.8 billion. 1/29/9: Launch date. Sold at /8/1: Closed at ( 88.7%). 11/9/1: 1-for-4 reverse split. Closed at /3/12: Close at ( 63.%). VIX ETP market: Performance Personal favorite is VXX. 6 Share price Shares outstanding 14,, 5 12,, ,, 8,, 6,, 4,, 2,, reserved. 12

13 VIX ETP market: Performance Why has short-term index performed so poorly? Contango : VIX futures curve is usually upward sloping. Consider curve on March 19, VIX futures prices Days to expiration VIX ETP market: Performance Why has short-term index performed so poorly? VIX Spread reserved. 13

14 VIX ETP market: Destabilization Leveraged and inverse products complicate matters. ETPs must be rebalanced at end of each day. Adjustment to notional amount of futures position to maintain neutral position is 2 ( ) NAVt L L R t + 1 where L=1 (as with traditional ETF), no futures rebalancing. where L<>1, futures rebalancing is required and is always in same direction as index move. VIX ETP market: Destabilization Illustration: Consider double-leveraged ETN (L=2). Leverage factor 2 Notational amount of futures hedge Notional Dollar Notional Adjustment Index Index at beginning change at end to futures Percent Formula Day level return NAV of day in value of day hedge adjustment value % % % % 16 Amount of rebalancing is huge and in same direction of index move. Trading is inherently destabilizing and leads to front-running. reserved. 14

15 VIX ETP market: Destabilization Illustration: Consider inverse ETN (L= 1). Leverage factor -1 Notational amount of futures hedge Notional Dollar Notional Adjustment Index Index at beginning change at end to futures Percent Formula Day level return NAV of day in value of day hedge adjustment value % % % % 22 Inverse ETNs require even greater rebalancing in same direction of index move. Note rebalancing is in same direction for double-leveraged and inverse ETNs. VIX ETP market: Destabilization 4, 3,5 Hedging demand Open interest Market value in USD millions 3, 2,5 2, 1,5 1, reserved. 15

16 VIX ETP market: At what cost? Most active VIX ETPs are not suitable as buy-andhold investments. Systematically lose money due to contango trap. Re-hedging demand reinforces steep term structure. Should not be considered asset class. Are retail customers being harmed by ETPs? Should SEC allow complex futures trading strategy to be public stock? Levered and inverse products are inherently destabilizing. reserved. 16