The CBOE Volatility Index, or VIX, is a measure of the market’s expectation of volatility (one standard deviation of returns) in the S&P 500 (INDEXSP:.INX) over the next thirty days (as evidenced by the implied volatility of options the S&P 500). It turns out to be a good measure of future volatility, as the following chart indicates (h/t EconomPicData):
There are several exchange traded products (ETPs) which track the VIX, allowing investors to take positions based on their view of future volatility. Some focus on short maturities of the VIX, while others focus on longer maturities. Some use leverage and some are inverse products. The following handy chartshows the range of ETPs:
Two of the popular levered ETPs are the ProShares Ultra VIX Short Term Futures ETF (NYSE: UVXY) and theVelocityShares Daily 2x VIX Short Term ETN (NYSE: TVIX). TVIX recently made headlines when, just a month after its sponsor announced it would suspend creating new notes, the ETN traded at a 80-90% premium to NAV only to plummet in recent days (some believe this is due to information leakage relating to its sponsor’s announcement that it would begin creating new notes again, in part to close the premium).
UVXY followed suit with a similar (though lesser) decline, despite the fact that UVXY’s premium to NAV never exceeded 3%. This hints that something else is going on than a mere correction of an overpriced security (TVIX). One explanation (and I am sure there are others) is that the underlying asset these these ETPs track, the VIX, has been in free fall. In fact, as we see here, the VIX has fallen to its lowest level since mid-2007 (h/t Mark Perry):
As Perry points out, the last time the VIX was this low, the Great Recession was still six months away. At its current level of 14.26, the VIX is implying that one standard deviation of market performance for the next thirty days is +/- 4.12% (details on this simple calculation here). Twenty days ago, the market was implying +/- 6.14%, which is a significantly greater dispersion of possible returns. Simply put, the market is more confident in its assessment of the future.
When the market becomes more confident (by this measure, more confident than it has been since mid-2007), this is often a sign that investors should take pause and consider whether equities (the S&P 500) are “priced for perfection” or otherwise not fully considering the downside. There are certainly no shortage of reasons to be worried about problems abroad leading to issues for American companies, and many rightfully question whether we are in for a repeat of 2011, when a strong start gave way to continued weakness and massive (historically high) volatility.
Given the level of the VIX, one might wonder whether buying at a 5.5 year low could be a value play, especially when the market seems to be overconfident in the face of major risks. The hurdle appears to be lower today than at any other time over the last half decade, so could this be a “heads I win big, tails I just lose a bit” scenario?
Investing in a VIX ETP today carries with it significant risks which are not immediately obvious. To understand these risks, you need to understand how VIX ETPs work. First, recognize that futures have definite expiry dates, so to maintain the same maturity, ETPs have to roll into newer assets by selling aged futures in favour of new, younger maturities (think Hugh Hefner).
Second and this is probably an obvious point but it is really important: ETPs do not track the spot price of the VIX, but rather the price of futures contracts on the VIX. So we don’t care about the current price, however low it may be, but rather we care about what the futures prices are. When you plot the prices of different maturities of these futures, you get a term structure.
The VIX futures term structure is currently extremely steep (earlier this month, it was the third steepest it has ever been). A steep term structure means that the futures prices are more expensive than the spot price. So when these ETPs purchase futures contracts they are buying them at a level higher than what the current spot price is. This scenario is called contango, and it means that as time progresses, the price of that futures contract will decline as it converges on the spot price.
The difference between the spot price and the futures price when you buy it is essentially a premium whereby you are betting that the spot price will increase to the futures price rather than the futures