Trading volatility - portal.idc.ac.ilportal.idc.ac.il/en/main/research/caesareacenter/... · Trading volatility 5/11/2012 Copyright (c) 2012 by Robert E. Whaley. All rights reserved

Trading volatility 5/11/2012

Copyright (c) 2012 by Robert E. Whaley. All rights reserved. 1

Trading volatilityAt what cost?

TVIX



Trading volatilityOutline:

VIX futures and options marketsWhy trade volatility?VIX ETP market

Product offeringsTransparencyPerformanceDestabilization of VIX futures marketAt what cost?

VIX futures and options marketsCBOE started reporting in January 1993. VIX derivatives launched more than decade later.

VIX futures launched by CBOE Futures Exchange in March 2004.VIX futures options launched in February 2006.



VIX futures and options markets

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1,000,000

200403 200508 200612 200805 200909 201102

Aver

age

daily

trad

ing

volu

me

VIX futures VIX options

VIX futures and options markets

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

200602 200707 200811 201004 201108

Aver

age

daily

trad

ing

volu

me

VIX calls VIX puts



Why trade volatility?Risk management

Take directional view on market volatilityFundamental economics analysis

Why trade volatility?

0

20

40

60

80

100

120

140

160

1/2/1986 6/25/1991 12/15/1996 6/7/2002 11/28/2007

VIX

(%)

August 1990: Iraqinvades Kuwait

January 1991: US beginsmilitary action in Iraq.

October 1997 and August 1998: DJIAexperiences record losses. September 2001:

Terrorists attack World Trade Center.

April 2011: S&P downgrades US credit rating.

October 2008: Credit market collapse.

October 1987: Stock market crash



Why trade volatility?Risk management

Take directional view on market volatilityFundamental economics analysisStatistical analysis:

Implied volatility is mean-reverting.Deviation of implied volatility from realized volatility.

Hedge volatility exposureBuy calls to hedge “tail risk.”

Diversify.Use collateralized futures position to create new asset class.

Why trade volatility?Focus on diversification.

Maximize Sharpe ratio.

Note negative expected return for MT index.

S&P500 MSCI VIX MTExpected return 12.0% 10.0% -4.0%Expected volatility 24.4% 23.3% 32.2%Expected correlations

S&P 500 1 0.515 -0.776MSCI 0.515 1 -0.469

VIX MT -0.776 -0.469 1

Risky asset return/risk parameters



Why trade volatility?Optimal allocation is

28.74% of portfoliois invested in VIX MT futures volatility index.

-10%

-5%

0%

5%

10%

15%

20%

25%

0% 5% 10% 15% 20% 25% 30% 35%

Expe

cted

retu

rn

Volatility

Fractional weights 0.5192 0.1934 0.2874Maximum slope 0.5893Expected return 7.01%Risk 10.21%

Final risky asset portfolio

Why trade volatility? (Ogilvy station)



VIX ETP marketProduct offerings (March 30, 2012)

30 different ETPs8 most active are:

Average Asset value Date of Yearly Inst.Symbol Name volume in USD millions inception fee ST/MT TR/ER Factor owner.VXX iPath S&P 500 VIX Short Term Futures ETN 32,104,131 1,864.6 20090129 0.89% ST TR 1 30.4%TVIX VelocityShares Daily 2x VIX Short-Term ETN 13,344,642 355.7 20101129 1.65% ST ER 2 1.0%XIV VelocityShares Daily Inverse VIX Short-Term ETN 7,739,089 446.9 20101129 1.35% ST ER -1 40.6%UVXY Proshares Ultra VIX Short-Term Futures ETF 1,478,367 125.4 20111004 0.95% ST ER 2 30.4%VXZ iPath S&P 500 VIX Mid-Term Futures ETN 467,066 320.1 20090129 0.89% MT TR 1 38.0%VIXY ProShares VIX Short-Term Futures ETF 273,392 127.9 20110103 0.85% ST ER 1 22.3%SVXY Proshares Short VIX Short-Term Futures ETF 111,773 29.1 20111004 0.95% ST ER -1 5.0%VIIX VelocityShares VIX Short-Term ETN 91,465 35.0 20101129 0.89% ST ER 1 14.9%

Benchmark

About as active as Ford shares




Benchmark

As big as small S&P 500 stock






Benchmark

Management fees




Benchmark

S&P VIX futures indexes used as benchmarks.






Benchmark

Leveraged and inverse products




Benchmark

Institutional ownership



VIX ETP marketMarket value of largest 8 VIX ETPs

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

20090129 20090817 20100305 20100921 20110409 20111026

Mar

ket v

alue

in U

SD m

illio

ns

VIX ETP market: TransparencyETPs 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?



VIX ETP market: PerformanceHow well does VXZ track S&P VIX MT futures index performance?

Summary statistics:VXZ SPVXSTR

n 773HPR -45.93% -44.46%Volatility 31.78% 32.05%

Regression: VXZ on SPVXSTRα t(α ) β t(β ) R2

-0.00006 -0.33 0.95812 103.72 0.9331

0

20

40

60

80

100

120

20090130 20090818 20100306 20100922 20110410 20111027

VXZ

S&P VIX MT

Less than one basis point.

VIX ETP market: PerformanceHow have S&P VIX indexes performed since inception in 20051220?

0

50

100

150

200

250

300

20051220 20070504 20080915 20100128 20110612

VIX ST futures index VIX MT futures indexST ER MT ER

n 1,580 1,580Mean daily return -0.102% 0.017%Standard deviation 3.911% 2.041%Holding period return -93.9% -5.4%Compounded annual growth -36.0% -0.9%



VIX ETP market: PerformancePersonal favorite is VXX.

Recall VXX is highest market cap ETN at $1.8 billion.1/29/09: Launch date. Sold at 100.00.11/08/10: Closed at 11.29 (–88.7%).11/09/10: 1-for-4 reverse split. Closed at 45.39.3/30/12: Close at 16.78 (–63.0%).

VIX ETP market: PerformancePersonal favorite is VXX.

0

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

0

100

200

300

400

500

600

20090130 20090818 20100306 20100922 20110410 20111027

Share price Shares outstanding



VIX ETP market: PerformanceWhy has short-term index performed so poorly?

“Contango”: VIX futures curve is usually upward sloping.Consider curve on March 19, 2012.

15.04

20.00

22.8223.85

25.16 25.8626.69

12

14

16

18

20

22

24

26

28

0 30 60 90 120 150 180

VIX

futu

res p

rice

s

Days to expiration

VIX ETP market: PerformanceWhy has short-term index performed so poorly?

-50

-25

0

25

50

75

100

20040329 20050811 20061224 20080507 20090919 20110201

VIX Spread



VIX ETP market: DestabilizationLeveraged 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

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.

( )21t tNAV L L R +−

VIX ETP market: DestabilizationIllustration: Consider double-leveraged ETN (L=2).Leverage factor 2

Notional Dollar Notional AdjustmentIndex Index at beginning change at end to futures Percent Formula

Day level return NAV of day in value of day hedge adjustment value0 100 100 2001 90 -10% 80 160 -20 180 -20 -11.1% -202 99 10% 96 192 16 176 16 9.1% 16

Notational amount of futures hedge

Amount of rebalancing is huge and in same direction of index move.Trading is inherently destabilizing and leads to front-running.



VIX ETP market: DestabilizationIllustration: Consider inverse ETN (L=–1).

Leverage factor -1

Notional Dollar Notional AdjustmentIndex Index at beginning change at end to futures Percent Formula

Day level return NAV of day in value of day hedge adjustment value0 100 100 -1001 90 -10% 110 -110 10 -90 -20 -22.2% -202 99 10% 99 -99 -11 -121 22 18.2% 22

Notational amount of futures hedge

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

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

20090130 20090818 20100306 20100922 20110410 20111027

Mar

ket v

alue

in U

SD m

illio

ns

Hedging demand Open interest



VIX ETP market: At what cost?Most active VIX ETPs are not suitable as buy-and-hold 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.

Documents

Trading volatility - portal.idc.ac.ilportal.idc.ac.il/en/main/research/caesareacenter/... · Trading volatility 5/11/2012 Copyright (c) 2012 by Robert E. Whaley. All rights reserved