After taking quite a beating over the past few weeks due to its short exposure to the VIX, the ProShares Short VIX Short-Term Futures ETF (SVXY) has seen a bit of uplift, with shares increasing by over 8% in the last week. While the VIX is likely to remain volatile for some time, I believe that ultimately we are at peak VIX levels, and that going forward, buying SVXY is going to make for a winning trade.
If you’re familiar with VIX futures, contango, and roll yield, then the appeal of buying SVXY becomes pretty apparent. However, if everything I just mentioned sounded foreign, then this section is for you. Over the next few paragraphs, I am going to detail out exactly how SVXY works, as well as why I believe it makes for a solid long-term holding.
SVXY is an ETF which gives a one-half leveraged inverse exposure to the S&P 500 VIX Short Term Futures Index. This index is provided by S&P Global, and it gives the return of perpetually rolling exposure in VIX futures. Specifically, it constantly rolls exposure in VIX futures such that the weighted-average holding period is roughly 30 days into the future by utilizing the front two futures contracts.
The underlying problem with a long exposure (and hence, the appeal of SVXY) is the fact that VIX futures are largely in contango. What this tangibly means is that the front-month VIX futures contract tends to be priced higher than the second-month VIX futures contract. The magnitude of this difference in pricing can be seen in the following chart from VIX Central.
As you can see, we are in a bit of an unusual period in that the VIX futures market is actually in backwardation by about 10-15%. Historically, this is a very unusual time in that over the past 10 years, we have only been in backwardation in about 13% of all trading days, and most periods of backwardation switch back into contango within a week or so.
So why does this matter? Good question. The reason why this matters for traders of volatility ETPs is that there’s an often-overlooked tendency of futures and forwards markets for futures prices to move towards the spot price as time progresses. What this tangibly means is that through time, while the market is in contango, the futures contracts which are priced higher than the spot level of the VIX will be generally declining in value versus the front as a month progresses.
To get the theoretical concept, here’s a great graphic from Wikipedia that shows the theory in action.
What I really love about the above chart is that in a single glance, it captures exactly what is happening beneath the hood with the S&P 500 VIX Short-Term VIX Futures Index. The basic tendency of VIX futures is to remain in contango, since most of the time market action is normal, which means the risk of something abnormal / volatile occurring would be at some point in the future (hence, higher VIX levels along the futures curve).
This tangibly means that most of the time you will have futures priced above the spot level of the VIX, and these futures will be generally declining in value towards the spot as time progresses. In other words, if you’re holding a long exposure to the S&P 500 VIX Short-Term Futures Index, you will typically be losing money from this phenomenon most of the time (87% of all days over the last decade).
The issue is compounded by the fact that the VIX itself doesn’t trend very much. For example, in the ETPs which track commodities like crude oil, roll yield certainly is an issue, but the underlying movements of the commodity can obfuscate the effects of roll, and it really only appears through time. However, VIX is a funny instrument in that is almost always hovers in the 15-20 territory, and excursions beyond this range tend to see quick reversals back to normality.
Since the VIX itself rarely sees prolonged trends, this means that over time, most of the price movements of ETPs which give constant exposure to the index will largely be dependent on roll yield for long-run returns.
This is the theory at least – futures converge towards spot, and therefore, returns of volatility ETPs like SVXY will be largely dependent on roll yield. But does this hold up in the data? In the below chart, I have taken the last 10 years of market data and given a simple average of what the VIX was on a given day into a trading month compared to the average level of the first two months of VIX futures contracts.
As you can see, during a typical trade month (time between expiries of contracts), the VIX basically goes nowhere, as we can expect from our prior chart of the long-run returns of the VIX. However, the VIX futures contracts start a month substantially above the outright level of the VIX (contango) and narrow the distance towards the VIX as the month progresses.
In other words, the default expectation for the long-run returns of anything giving a long exposure to these two futures contracts through time will probably be losses, since the spot VIX generally doesn’t move much and futures are falling towards the spot. Put simply, financial theory works in practice, and long-run returns for long exposure to VIX futures should be negative.
To get an idea of how negative things can be, here’s a chart of the performance of the index which SVXY gives an inverse exposure to.
You are reading this correctly. Over the past decade, the S&P 500 VIX Short-Term Futures index has dropped at nearly a 50% annualized rate per year. In other words, roll yield has absolutely destroyed returns for this index, and shorting it has been a strongly winning proposition.
And this is the appeal of SVXY. It offers investors the ability to directly short the chart above at one-half leverage. This is why I suggest buying SVXY – it allows investors to short something which has fallen around 50% per year for the last decade. When you buy SVXY, you are shorting the losses from roll, which means through time, you will likely make money as this relationship continues.
As a note of caution, I would suggest that investors trade this instrument through options. In the past, I have traded options spreads (to strip out a good degree of implied volatility) on the instrument, and I believe that call spreads make for a good method of trading the instrument.
The reason why I suggest options is that when you’re trading these instruments, you’re earning the percent change of a percent (the level of VIX represents annualized volatility). In other words, things can be quite volatile. For example, if the VIX increases from 12 to 24, a short trade could be looking at a 100% loss depending on how the futures market behaves. A half-leveraged trade would maybe see this loss in the territory of 50%. In other words, the tail risk here is real and tangible. With an outright purchase of an option, your risk is confined to the premium, so in the event that volatility explodes suddenly, you will be just out the premium rather than potentially losing your account.
The recent surge in volatility represents an excellent shorting opportunity, since volatility is generally mean-reverting. Roll yield bears out both in theory and practice, which means that the long-term expectation for VIX ETPs is negative. Utilize options when trading the VIX so that you can limit your risk in true tail-event situations.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.