This introduction is broken into three parts.

  • Investors looking for reasons to trade volatility funds in the age of active Central Bank intervention should start here
  • Investors who already trade volatility and are seeking to gain an edge should go to the Profit From Volatility section.
  • Subscribers who needed a refresher on the terminology and formulas, should go to the Volatility Terminology section.

Pitfalls of Stock Picking

Americans love the stock market and they love owning stocks. Every investor has read Peter Lynch's classic "One Up On Wall Street: How To Use What You Already Know To Make Money In The Market". There is nothing quite like using a great product or service then buying the shares of the company, hold them for the long term and make multiples of your original investment. It is the essense of capitalism. Apple, Microsoft, GAP, Procter & Gamble, the list goes on and on. It's easy, buy an iPhone, own Apple and go on nice vacations with the extra profits.

And while it sounds easy in theory, in practice the reality is a little more sober. One Up On Wall Street For every success like Apple, there are five "failures" like Microsoft. While Microsoft is an excellent company, MSFT hasn't been a good investment since 2000, when most investors of my generation were of age to invest. While Microsoft has tripled and quadripled its revenues and profits since 2000, the stock has been mired in a long term stagnation The stock market is full of these types of "value traps". At the same time a company like Amazon or Salesforce, which haven't seen much profitability have skyrocketed. Fundamental analysis alone does not explain or provide a clear guideline to success in the stock market. Stock market prices are driven largely by sentiment and what the combination of institutional and retail investors think about a stock. It is positive sentiment and optimistic forward expectations that makes unprofitable stock push higher and negative sentiment and pessimistic forward expectations that make a highly profitable dividend payer trade lower.

In addition to the difficulty in spotting sentiment correctly (apart from the stock price not making any sense), individual stock investing carries substantial risk. An individual stock can lose 25% of its value in a single day if it disappoints on earnings. It can lose 50% of its value, if the chief executive resigns suddenly. It can lose 80% of its value in a single day, if a class action lawsuit is filed against the company. Most of that happens without a forewarning and investors are left smarting about what happened. And once you lose 50%, you need to make 100% to get your money back. Finding stocks that double is much harder than finding stocks that drop 50%. For that reason, most investors diversify their portfolios and invest in 10 or more individual stocks.

Tracking 10 or 20 different companies is tedious work, however. Checking the earnings every quarter, reading SEC disclosures, following the business, evaluating competitive threats, etc is very time consuming. If you are a professional worker like a doctor or an engineer, most of your time is spent keeping up with your professional requirements - learning new techniques, keeping certifications current, etc. Between work and family, there isn't a whole lot of time to keep up with 20 stocks. So with the limited amount of time and information that people have, most retail investors are simply gambling in a game that has much better odds than horse racing. Investors with truly successful portfolios are few and far in between. Among ten million investors, 0.1% or 100,000 will get the right combination of 20-30 stocks out of the 5000 issues that can be traded. Those 100,000 will consider themselves good investors. But are they really good or is it just plain luck? If you are not a professional investor who spends all day poring over SEC disclosures, chances are you are lucky and I can only hope you know it.

Measured Risk Strategy Fund MRPAX MRPIX

Rise of ETFs

The uncomfortable reality of stock picking has lead to the rise of ETF investing where investors get rid of individual company stock risk and instead trade a basket of stocks together usually bundled around a theme - whether it is US economy via the SPDR S&P 500 ETF (SPY) or technology via PowerShares Nasdaq ETF (QQQ) or US treasury bonds via the iShares 20+ Year Treasury Bond ETF (TLT) or gold via the SPDR Gold Shares (GLD), etc. There are now tens of thousands of ETFs for every taste and flavor.

ETF investing also brings the retail investor closer to the institutional investor. Institutional investors are a group comprised of state and large company pension funds, college endowments, hedge funds, proprietary desks at banks and other deep pocketed investors. They generally look at the investment universe in terms of asset classes - stocks, bonds, commodities. Every day they have to make decisions where to allocate their money - should they be in stocks, bonds or commodities. Most well run institution have investment committees comprised of portfolio construction specialists, risk specialists, economists and other market and stock research groups. All of them have to agree before an investment is made. And they have a plethora of systems and investment tools built over time that enable them to make good decisions.

While retail investors now can allocate money in a similar way, they simply don't have the same decision making firepower. ETFs just like individual stocks move up and down and thus carry investment risk. Any given asset class or ETF can experience a 50% drawdown at any time. The S&P 500 Index (SPY) has had two 50% drawdowns in the last 15 years. The NASDAQ lost 80% of its value after the dot com bubble burst. Gold is currently in a 40% drawdown. The Japanese stock market went through an 80% drawdown over 20 years in the 90s and 00s. And while ETFs carry risk, the moves and the volatility are far less dramatic than invidividual stocks and as such should still be the prefered vehicle for investing.

The Ugly Mathematics of Investing

The mathematics of investment loss and getting back to even are very succinctly expressed by Warrent Buffet's famous maxim "Rule #1 of investing is don't lose money. Rule #2 look at Rule #1". While most of the investment literature out there focuses on the beauty of compounded interest and the fantastic gains it can deliver over a long period time, what it conveniently omits is that every asset has a price and that price fluctuates up as well as down. And if the price goes down over a sustained period of time, compounded interest/dividends may not be able to recover your original investment. If your investment is down 20%, it needs to go up 25% for you to recover your original investment. If it goes down 30%, it now needs to go up 43% to break even. If it goes down 50%, the gain required is 100%. If you lose 60%, you need to go up 150% to break even. The harder the investment falls, the bigger the climb required to get back to even. And once an asset class is out of favor, it is not at all certain that it will gain traction again soon. Sometimes it takes decades for asset values to recover (see NASDAQ or Japan for example).

Rule #1 of investing is don't lose money. Rule #2 look at Rule #1
Large cap US stocks in the S&P 500 (SPX), which are underwritten in the reserve currency of the world and have had the explicit support of the Federal Reserve since at least Greenspan and are considered to be one of the safest investments in the world, have had two 50% drawdowns in the last 15 years! If an investor can experience a 50% drawdown in the S&P 500 index, he can experience far worse in any other asset class. So an investor still needs to make a decision when to be in an asset class and when to be out.
Sticking through the bad times is not a strategy that works in investing
Most new investors inevitably try to stick through the hard times as that is what works so well in real life. But muddling through inevitably hurts the their net worth and investment capital. They have less than when they started. They could've used the money to buy something nice. Investors generally don't have 10 or 20 years to wait for their investment to recover. Or maybe some do, but that is a lot of time lost waiting with nothing to show. Investors of the Gen X and later generations have lots of educational and mortgage debt. Unlike the baby boomers and earlier generations they didn't have the option to spend 10K on education and 100K on a house. The numbers are at 100K and 500K now and younger investors simply don't have the luxury of getting in late on an investment. They also don't have the luxury of 10%, 7%, 5%, 3% or even 1% interest rates to help them save and accumulate an adequate financial cushion.

So inevitably, investors are confronted with the issues of valuation (is the investment expensive or cheap) and the issue of timing (should I get in/out now or later).

Timing the Market

While the mass media tends to frown on market timing and belittle it, the real truth is that market timing is the essence of capitalism. On a free market assets can be cheap and they can be expensive. You can't realize wealth without selling. Before you sell, you need to buy. In order to be a buyer, you need to have capital. If you didn't inherit your capital, you must have sold something first to obtain that capital. So the generation of wealth is a progression of buying and selling activities. Buying and selling is the defining feature of the US stock market and free market capitalism, not buy and hold.

In fact, America's best investors are market timers. Warren Buffet never buys an expensive stock. He waits until the valuation is below the fundamental cash flow valuation to buy. When the market doesn't present properly valued opportunities, Warren Buffet waits patiently in cash. George Soros, David Tepper, John Paulson, etc - America's best private investors are market timers. In fact, even in the banking system, market timers rule. Lloyd Blankfein, the CEO of Goldman Sachs, is quietly considered to be the best market timer alive. Starting as a commodities trader at J. Aron & Company, he rose through the ranks to the top, engineered a marriage up acquisition by America's most prestigious financial institution and has successfully navigated its trillions under management over the past 40 years through many bull and bear markets. And a replacement has been hard to find. His market timing skills are the reason why he still is the CEO of Goldman even through all the scandals that have marked his tenure.

So, au contraire, market timing is the essense of investing and a good investor should be able to time the market with reasonable precision.

Measured Risk Strategy Fund MRPAX MRPIX

Why Trade Volatility?

The answer is short: Trading volatility products can help you hone your market timing skills.

Volatility didn't exist as an asset class until 2009. The first widely available volatility ETF - iPath S&P 500 VIX Short Term Futures ETN (VXX) - was launched in January 30th, 2009. VelocityShares Daily Inverse VIX Short Term Futures ETN (XIV) arrived in November 30th, 2010. SVXY (1x short volatility) and UVXY (2x long volatility) were launched in October of 2011. Today there are many other volatility ETFs - VIXY, VXZ, VIXM, XVIX, VIIX, VIIZ, ZIV, etc. I am not going to cover them all, but if you want a complete list, you can find it here. Volatility is a fairly new asset class and as a result there isn't much literature available and most investors are unfamiliar with it. I will try to provide a list of resources below for those interested in delving further.

It is important to understand that while volatility ETFs are influenced by the VIX, they do not move in 1:1 tandem with the VIX. VXX can go down while the VIX is going up. XIV can go up while the VIX is going up. The reason is the implementation of the ETFs. In order to mimic the VIX, these ETFs buy and sell VIX futures traded on the Chicago Board of Exchange. The buy/sell process tries to mimick the VIX but is generally unsuccessful and is instead primarily influenced by the shape of the VIX Futures Curve. As a result, some volatility ETFs far outperform the VIX itself and some far underperform it. This site will help you navigate the basic volatility ETFs successfully.

It is a core mandate of the Central Banks to suppress price volatility

But still, why trade volatility? In this age of Central Bank intervention in the publicly traded markets of bonds and stocks, it is critical to understand that it is a core mandate of the Central Banks to suppress volatility. After all, "stable prices" is mandate #2 of the Federal Reserve. The Central Banks do not want the S&P 500 index to go down 50%. In fact, they don't want it to go down 10%. They want the index to go up or trade in a small range at worst, regardless of fundamental valuation. Stock market panics and large drawdowns have had large spillover effects on the broader economy and in 2000 and 2008 brought about recessions. The FED and other Central Banks want to avoid a repeat of those episodes and as such deploy rarely announced techniques to suppress volatility and honest price discovery. The Bank of Japan, for example, buys stock futures in the open market. Central Banks of other smaller countries also purchase stock futures. In fact, the Chicago Mercantile Exchange (CME) has a Central Bank Incentive Program where non-US Central Banks can buy S&P 500 E-mini Equity Index Futures and Options at a discount. Whether that is right or wrong is above my pay grade, the point is that it is happening and as an investor, you can take advantage.

Volatility ETFs and ETNs enable you to trade Central Bank policy directly

How To Trade Volatility

You can gain an edge in these Central Bank controlled markets by including outperforming volatility products in your portfolio. After all, you do know volatility is being supressed. What you don't know is whether companies will continue to increase earnings. You don't know with certainty if companies can match with earnings, the price assigned to them by the market. In 2015, they have been failing in that regard and as a result the P/E ratio of the SPX has continued to grind higher and higher. However, as valuations soar, it gets harder and harder for stocks to appreciate significantly on a percentage basis.

So instead of being blindsided by earnings and company valuations, you can simply trade Central Bank policy directly. You can accomplish that via the volatility ETFs and ETNs.

The biggest volatility ETFS by market cap are:

ETF/ETN Description Market Cap Note
VXX S&P 500 VIX Short-Term Futures ETN $1.1 billion This is a 1x long volatility ETF. It is supposed to match the daily movemement of the VIX. While its correlation with the VIX daily movement is over 90%, due to contango issues this product can be a major money loser. Primarily used by professional day traders. Retail investors with longer time horizons should not use it for hedging purposes.
XIV Daily Inverse VIX Short-Term ETN $560 million This is a 1x short volatility ETF. It is supposed to match the reverse of the daily movement of the VIX. While it has excellent correlation with the VIX daily movement, due to contango this product has significantly outperformed its benchmark. Retail investors should look to have at least 10% exposure to this product.
UVXY Ultra VIX Short-Term Futures ETF $400 million This is a 2x leveraged long volatility ETF. It is supposed to match double the daily movement of the VIX. Just like VXX, it is a major money loser but at double the rate! Do not touch with 10 foot pole.
SVXY Short VIX Short-Term Futures ETF $200 million Same as XIV

Since, you know volatility is going to be suppressed by the Central Banks, your attention should be focused on the short volatility ETF/ETNs - XIV and SVXY. XIV and SVXY are essentially the same product, so going forward I will discuss XIV but the same observations apply to SVXY as well.

The edge of the short volatility ETFs can be somewhat spectacular, especially in light of the risk undertaken. Since 2012, the short volatility ETF XIV has significantly outperformed the SPY. Some years in a dramatic fashion. In the bull market years of 2012 and 2013, XIV returned in excess of 100% on the year.

Your attention should be focused on the short volatility ETF/ETNs - XIV and SVXY
Since 2012, the XIV is up north of 500% compared to the 86% for the SPY. Some compare the XIV to a leveraged SPX product like UPRO. While that observation is generally true, it is important to understand that volatility marches to its own drum. The XIV will outperform the SPY during periods when the SPX is trading in a tight range and the XIV can post massive losses in a flat year for the SPX which is marked by extraordinary volatility like 2011. So in order to trade volatility successfully, you need to understand volatility itself and what drives the ETFs. Ultimately once you understand it, you will become a much better market timer and you will be able to protect your portfolio successfully against the vagaries of the stock market.

Measured Risk Strategy Fund MRPAX MRPIX

How Do Volatility ETFs Work?

The VXX buys VX2 futures and sells VX1 futures on a daily basis. The XIV shorts VX2 futures and covers VX1 futures on a daily basis. The closer we are to VX1 expiration, the smaller the amount of VX1 futures and the larger the amount of VX2 futures that are traded. The amount is proportional to the time to expiration. The daily weights of the VXX and XIV are available for subscribers of this site on the front page.

Because of the heavy reliance on VX1 and VX2 futures inside the Volatility ETF/ETNs, Contango is a very imporant indicator for traders of the VXX and XIV

So long as the Contango is positive and high that results in automatic increase in the XIV even if the SPX, spot VIX and VX futures are flat for the day. That same dynamic results in automatic decrease for the VXX. For example, if the Contango is 10%, that usually means the XIV will increase 0.5% automatically provided there are no changes to the VIX. Why 0.5%? Because you divide the Contango by the amount of trading days during the VX1 contract term. Only that that portion of futures inside the ETF gets rolled over on a given trading day. Usually, VX future contract terms are either 20 or 25 trading days (4 weeks or 5 weeks). So you divide 10% by 20 to get to 0.5%.

If average contango is high, over time XIV (Short Volatility ETN) can be expected to gain value above the average reduction in the spot VIX. This explains the XIV outperformance over the S&P 500 index and it is important to understand that it is not an accident and it is not something that is propped up artificially high because "there a lot of buyers". The Volatility ETFs stick to their formula and if there is additional demand, they simply issue more shares. If there is less demand, they reduce the share count. But the share price of the ETFs follows the mathematical formula, period. As such the XIV gains value based on VIX Futures fair value math and contango. So long as spot VIX is low and contango high, there is no limit to how high XIV can go. And vice versa, there is no limit to how low VXX can go.

VXX Warning
While the VXX is advertised to the general public as "portfolio insurance" product, it is anything but. Due to contango, the VXX may not rise when the market falls down. If contango is high and the market is slowly grinding down, the VXX will lose money daily. More often than not, the VXX will contribute significant percentage losses to your portfolio. Unless you are a day trader with volatility expertise, you should avoid investing or trading in VXX or other long volatility products.

Contango alone, however, doesn’t tell the whole story with regards to the XIV. If the market drops and the VIX Futures Curve gets reset higher, the Contango is of lower importance now as what was formerly shorted VX2 at 15 (for example) inside the XIV, now has to be covered as VX1 at 17 for a loss. This is what causes the XIV to post massive daily losses during one or two day sell-offs in the market and why if the entire futures curve moves higher, the XIV can start to lose you money quick. That is why while the XIV can be a very powerful passive investment instrument, it still needs to be monitored constantly in order to avoid the large percentage drawdowns that inevitably come about (see performance of XIV in the back half of 2014).

Additional Resources

Volatility is an emerging financial product and is mostly geared towards professional investors. While there is plenty of information about the VIX and related products on the CBOE website, it is not exactly easy to digest. A retail investor is best served following the Twitter accounts and blogs of some of the more well-known names in the volatility space.

Expert Twitter Website/Blog
Vance Harwood @6_Figure_invest sixfigureinvesting.com/blog
Bill Luby @VIXandMore vixandmore.blogspot.com
Eli Mintz @VixCentral vixcentral.com
Jay Wohlberg @tradevolatility tradingvolatility.net
Juan Ramon Velasco Barros @jvelaskoo investing.kuchita.com

Helpful Links

List of Volatility ETFs
Rule of 16
How does the VXX daily roll work
Unraveling The VXX Roll Yield Riddle
The Cost of Contango
VXX Daily Pricing Model
XIV Daily Pricing Model
Calculating the Fair Value of VIX Futures
Easy Volatility Investing (Tony Cooper paper)
VIX Contango Oscillator - Profitable Observations