Say Hello To The New Uptrend In VIX And VIX Futures

Recap of the Week: 4/7/14 - 4/11/14
We saw a bit of weakness in the market last week with SPX down 3 of 5 days. VIX largely took the movement in stride, indicating that market participants continue to believe that dips will be bought, or at least, that this particular dip will be bought. We saw a signal to sell XIV / buy VXX on 4/10 as the VXX Bias and WRY MACD moved to positive on Thursday. The next day we saw VIX move as high as 17.85, before closing at 17.03 (+7%). This value of VIX is unusually low for a situation where SPX lost 3% over the course of 2 consecutive days (actual volatility for the week was 19.5). A VIX in the low/mid-20s would be more appropriate given historical comparisons (see this tweet after this Thursday's 2% sell off). No, the VIX is not "broken" here -- this just indicates that market participants do not see the need to buy puts to hedge their positions since the market has been in the pattern of quickly recovering from 5% dips in this new QE era.

Key Points & Outlook
- After a false break lower the week of 3/31 - 4/4, VIX opened up higher this week, retraced to last week's close by Wednesday, then continued up to close at a 4-week high. This kept the longer-term uptrend that started the week of 1/21/14 intact. VIX weekly chart, below, shows the 9-ema rise above the 36-ema and test it twice so far. Also note the positive slope of the 36-EMA and 50-SMA.


- (Remaining Key Points & Outlook are available to Members only. Please login to the Members' Forum to read the remainder of this article. If you're not yet a member you can join via the Subscribe page.)
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Major Shifts In Volatility Structure
We've watched many significant developments in the world of VIX and VIX futures unfold over the past two months and have been discussing these events and their implications in our Members' Forum. Below I've jotted down a summary of points from our recent posts to provide a glimpse of these conversations. 

(You can get access to the Trading Volatility Forum as well as our VIX Futures data and analytics for just $40/month. See the Subscribe page for details.)

2/24/14 - Theme: Rising actual volatility (HV20 & HV60) in the S&P 500 is a sign of an aging market and signifies shifting market sentiment.
- VIX has shown a bit of reservation over the latest two week rally.
- Do not expect XIV to behave in the same way in 2014 as it did in 2013; Expect choppy trading and weaker bounces like what we are seeing now. 

2/28/14  - Theme: Disappearance of the roll yield and a higher VIX base
- VXX Bias has narrowed -- almost no negative roll yield in VXX since early Feb
- VIX making higher lows, forming base in 14s
- Near-term VIX futures not selling off this time around. Trending up since Feb 18.
- Investors not selling VIX futures this time around

3/18/14  - Theme: Market Indecision and VIX Doubt In The Latest S&P Rally
- VXX Bias remains thinly negative
- VIX indicating lingering uncertainty despite S&P rally
- Continued rise in level of actual volatility in SPX, specifically HV60
- VIX/VXV bouncing above & below 0.92 threshold, indicating a high level of indecision

3/28/14  
- Continued indecision with VIX range-bound
- Watch for development of more negative VXX Bias

3/31/14 
- Break of the VXX trendline indicates lower prices to come

4/3/14 
- Weak market action in NDX and Russell 2000 prompts reduction in XIV position. Not a good time to aggressively short volatility.

4/4/14
- No show of fear yet despite selling in SPX. Watch out for further downside on Monday (4/7), 

4/10/14
- Change in VXX Bias and WRY MACD signal a move higher in VXX. 



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Shorting Volatility: Time To Reduce Profit Expectations for 2014

With XIV down 7.6% so far this year after seeing 100%+ annual returns in both 2012 and 2013, many have been asking "Is the short volatility trade dead in 2014?" While my terse answer is "not necessarily," we need to take a closer look at the various aspects of the VIX futures market in order to gain some insight on where VIX ETFs could be headed.

The idea of reduced profit expectations for XIV is actually not new. Although XIV gained 107% in 2013, its gains have slowed to just +36% over the past 12 months. While we've talked about this several times last year (here and here and here), today we'll talk about why and take a look at the current outlook.


VIX Futures
The daily price movement of XIV/SVXY, VXX and UVXY/TVIX are determined by the price of the front two months of VIX futures. In the chart below you can see both front month (M1) and second month (M2) VIX futures over the past 12 months.



Current values of M1 (14.85) and M2 (15.75) are generally in the lower-middle portion of the range. We've seen these M1 & M2 price levels with a similar ~1 point spread before. In fact, M1 and M2 are essentially unchanged from 12 months ago and we've seen the same levels six other times during the past year (4/26, 7/29, 9/16, 10/30, 12/3, and 12/19). On all of these occasions we've seen M1 and M2 continue to fall, providing an average gain for XIV of 9% over the next 1-2 weeks. These gains tend to be short-lived as multi-day volatility spikes have resulted in 15%+ drawdowns in XIV for 5 of the 7 instances (exception were 10/30/13 and 12/3/13). This doesn't mean that the same thing will happen this time around, but it does provide some interesting data points.

We can see these moves reflected in the 1-year chart of XIV, below. While VIX futures are essentially unchanged over the past 12 months, monthly expiring futures and the roll yield continue to provide fuel for gains in XIV, which is +36% over the past 12 months (and VXX is -47%). There's no reason this dance can't continue at this "slower" rate as long as M1 and M2 remain range bound under 20, but periodic drawdowns are likely to continue resulting in choppy trading.



As a relevant side note, 3 month actual volatility in the S&P 500 (HV60) has risen about 1.3 points over the course of the past five months. This often serves as an approximate lower-bounds for VIX, as we can see in the HV-IV chart below (see green circles). This means VIX is less likely to soon push back down into the 11.9/12.3 range we saw late last year.



VXX Roll Yield
In addition to looking at the relative position of front month VIX futures, we need to also look at the headwind/tailwind for the securities that arises from the roll yield. The roll yield is proportional to the difference between the 1st and 2nd month VIX futures. Below I've charted VXX's weekly roll yield (WRY) over the past two years.


You can see how the roll yield for VXX has been much less negative so far this year, providing for less of a headwind for VXX and less of a tailwind for XIV/SVXY. In fact, so far this year the average VXX WRY has been just -0.7% (which is +0.7% for XIV). To put that number in context, below is a table of the average XIV weekly roll yield for each of the past 9 years.

XIV: Average Weekly Roll Yield vs. Annual Return
Year Avg WRY Annual Return
2005 1.6% 101%
2006 1.4% 14%
2007 0.6% -35%
2008 -0.6% -71%
2009 0.9% 118%
2010 2.1% 144%
2011 0.5% -46%
2012 2.1% 154%
2013 1.6% 107%
2014  0.7% -8% (YTD)


The 2014 average WRY is more or less in the middle of the range between the low (-0.6%) and high (+2.1%). So why is this important? Because the return of VIX ETFs is largely dependent on the roll yield. as illustrated by a scatter plot for the above table.



You can largely expect that the return of XIV 2014 will end up somewhere along this line. Think about this chart for another minute. Essentially the trendline is telling us that XIV needs an average WRY of at least 0.5% to have a chance at being positive for the year. Factor in a few 25%+ XIV drawdowns and realistically it needs an average WRY of 1% to really provide some confidence in the trade. With VIX futures already quite compressed along the entire term structure, that 1% WRY will be difficult to maintain unless M1 is able to spend much more time in the 13s. This would imply a VIX down in the 11-12 range -- quite a tall order at the moment.

Outliers on the graph above are the result of either a) major differences of the yearly starting and ending values of M1 (i.e. in 2009 M1 went from 45 to 20), or b) large multi-day volatility spikes that cause major (50%+) drawdowns in XIV (e.g. 2006, 2007, 2011) which are difficult to recover from based on the dynamics of percentages (i.e. it takes a 100% gain to fully recover from a 50% loss). For reference, below is a chart showing the value of front month VIX futures over the past 9 years (note that while M1 is low compared to the recent 5 years, it is still higher than most of 2005 and 2006).




VXX Forecast Review
As I turn to look at our daily VXX Bias Forecasts history, below, you can see why we identify the area between -1 and +1 as a "neutral zone" (highlighted in yellow) which is subject to a certain amount of thrash. These are are times when VXX generally moves sideways and is more susceptible to spikes. After looking at this forecast history it's not much of a surprise to learn that neither VXX (-1.7%) nor XIV (-7.6%) have gone anywhere this year.



Summarizing the current situation for XIV (and VXX/UVXY):
  • We've seen a narrow XIV weekly roll yield so far in 2014, but it has been increasing lately to the point where it is back above 1%. If XIV is going to continue to see gains the WRY needs to stay above this level. 
  • VIX futures are at the lower end of the range over the past few years. They've been at these levels and can continue lower, but their downside is more limited than the upside at this point, making for a pretty non-ideal time to aggressively short volatility. 
  • XIV has the potential to continue to rise as VIX futures roll forward each month. The next expiration date is April 16th.

Trading Plan (Member Access Only)
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March Update: Enhancements to Bias Indicators For VXX, XIV, and ZIV

Last year we launched our Bias forecasts as a primary resource for monitoring the headwind/tailwind of VXX, XIV and ZIV. Up until now these forecasts have been generated based on the primary driver of VIX ETPs over long periods of time -- the shape of the VIX futures term structure.

However, the term structure only tells part of the story and does not account for short term changes in price direction. Providing a major improvement to accuracy, we've updated the Bias indicators to include inputs from the WRY MACD indicator and the VIX/VXV ratio. The backtested results of the new Bias indicators are shown below.


Bias Performance For Near-Term VIX Futures ETFs (VXX & XIV)
The market structure frequently changes and it's important to understand how a strategy performs over a variety of time conditions. Below I've broken up performance into 3 different sections: 1) 2012-present, 2) 2009-2011, and 3) 2006-2008. In each section I've further divided into "short volatility" and "long volatility" sub-sections to highlight strengths and weaknesses of the strategies in different markets. Notes: Price data for VXX and XIV prior to their inception date has been derived from the values of VIX futures. All performance charts of Bias strategies involve reinvesting gains.  For results of the strategies using constant position sizes, see the links to the data pages, below. See the "hypothetical portfolio disclaimer" at the end of this post.

VXX Bias, 2012-present (Data link)
1A) This most recent market period has been characterized by a nearly constant state of contango across all VIX futures along with declining volatility. The result is an extremely strong performance with a "buy and hold" XIV strategy netting a +368% return. The performance of the updated Bias indicator for "shorting volatility", which involves buying XIV whenever the VXX Bias is negative, resulted in a return of +504%.



"Negative VXX Bias" Trade Histogram showing the size of gains & losses per trade:



1B) On the "long volatility" side, which involves buying VXX whenever the VXX Bias is positive, the "Positive VXX Bias" strategy resulted in a return of -21%.



"Positive VXX Bias" Trade Histogram showing the size of gains & losses per trade:




VXX Bias, 2009-2011 (Data link)
2A) In this timeframe we saw a variety of market conditions, including long periods of contango as well as sustained backwardation. During this time XIV returned +229%, which included a 52% loss in May 2010 and a 75% loss in Aug 2011. The "Negative VXX Bias" strategy resulted in gains of +1,332%, allowing the investor to avoid the steep losses caused by sustained periods of backwardation.



"Negative VXX Bias" Trade Histogram showing the size of gains & losses per trade:



2B) With a sustained period of backwardation, the "Positive VXX Bias" strategy during this time resulted in a return of +100%.



"Positive VXX Bias" Trade Histogram showing the size of gains & losses per trade:




VXX Bias, 2006-2008 (Data link)
3A) While the market in 2006 was largely characterized by persistent contango, 2007 and 2008 was a time with narrow contango and periods of backwardation. It also featured an out-of-the-blue, one-day VIX spike from 11.15 to 18.31 (+64%) with XIV dropping 25% on 2/27/07, as well as an 80% decline in XIV from Sept-Nov 2008. If there is a cautionary tale about the potential declines in XIV, this is it. XIV returned -78% over this time, while the "Negative VXX Bias" strategy resulted in -8%.



"Negative VXX Bias" Trade Histogram showing the size of gains & losses per trade:



3B) The "Positive VXX Bias" strategy during this time resulted in a return of +130%, mostly due to a sustained period of backwardation in late 2008.



"Positive VXX Bias" Trade Histogram showing the size of gains & losses per trade:





Bias Performance For Medium-Term VIX Futures ETFs (ZIV)


ZIV Bias, 2011-present (Data link)
With limited data available for ZIV, backtested results are only available back to 2011. While ZIV is up 209% during this time, the "Positive ZIV Bias" strategy is up 362%. As with the VXX Bias, the ZIV Bias indicator allows the investor to avoid owning the security during times of backwardation.



"Positive ZIV Bias" Trade Histogram showing the size of gains & losses per trade:





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Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance result that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.




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VXX WRY-10SMA Indicator Updated -- Now the "WRY MACD" Indicator

In late December we introduced a new strategy for trading volatility ETPs which looked at the Weekly Roll Yield ("WRY") for VXX at the end of each day and subtracted it from its 10 day simple moving average. The strategy provides more frequent trading signals than the Bias forecast and can help traders better avoid short-term drawdowns of XIV.

Today I'm excited to announce that we've updated the strategy to reduce the amount of signal noise by utilizing exponential moving averages. The result is 30% fewer trades and substantially improved performance in our backtested performance. The new chart will be published daily at the same location on the VIX Futures Data page.

The original WRY-10SMA chart looked like this:




In the new methodology which utilizes the 5EMA and 8EMA of the VXX WRY, the chart looks like this:



As you can see it is a very similar graph, but the WRY moving average lines (blue and purple) are smoother to reduce false signals and choppy trading.

Since we only care about whether the 5EMA is above or below the 8EMA, we've taken the update one step further to help simplify the chart and make it easier to identify when the lines cross. We replaced the two EMA lines with one line, by taking 5EMA minus 8EMA (Note: This is essentially a variant on the standard MACD calculation). Left axis is the MACD signal, while the right axis is VXX price.



Trading Strategy
A positive MACD value indicates that VXX is rising. A negative MACD value indicates that VXX is falling. Therefore, the strategy is to be short VXX (or long XIV/SVXY) when the MACD value is negative, and long VXX when the MACD is positive. The best results in a hypothetical portfolio are obtained by using the WRY MACD indicator along with our Bias forecasts to trade in the same direction of a VIX ETPs current bias. As noted in the announcement of the original version of this strategy (WRY-10SMA), gains from being long VXX when the bias is negative will tend to disappear quickly and sometimes turn into losses so it is usually best to take gains early and/or set trailing stops. Similarly, being short VXX when its Bias is positive and MACD is negative will not produce consistently good results.

Performance Testing
We previously outlined the performance of the WRY-10SMA strategy in this post. The new backtested performance is as follows:

A) Negative WRY MACD, 2013 (Link to Data)





Cumulative Return Jan 1, 2013 - Dec 31, 2013
  • XIV: +107%
  • "Negative WRY MACD": +141%
"Negative WRY MACD" Trade Summary, 2013 
  • # of Gains: 9
  • # of Losses: 5
  • Avg Return: +6.9%
  • Max Gain: +36.0%
  • Max Loss: -6.5%

For the period 2009-2013 the results for the new strategy did not change much versus the WRY-10SMA strategy. Note the undesirable drawdown in the 2nd half of 2011 when trading against a positive VXX Bias. (Link to Data)



B) Positive WRY MACD, 2013



"Positive WRY MACD" Trade Summary, 2013
  • # of Gains: 5 
  • # of Losses: 9 
  • Avg Return: -0.8% 
  • Max Gain: +11.0% 
  • Max Loss: -11.5%



Full data links of backtested results:
Old: WRY 10SMA, 2013 Performance
New: WRY MACD, 2013 Performance

Old: WRY 10SMA, 2009-2013 Performance
New: WRY MACD, 2009-2013 Performance

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Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance result that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.


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2014: Is It Still Profitable To Be Short VXX?

The markets are off to a bit of a rocky start to the year, particularly in the last couple of weeks. This is a distinct change of pace after a rather quiet end to 2013. VXX is +6.84% YTD after hitting a high of +30% on Wednesday. Will VXX see another year like 2012 and 2013 with losses of 60%? Or are we likely to see performance closer to 2011?

In this post I'll cover:
  • VIX Technical Review
  • Forecast Review
  • Trading Outlook
  • Trading Plan

VIX Technical Review 
VIX broke out above its 200SMA (14.4) on Jan 24 to start a rally that peaked at 21.48 seven days later. Since then it has quickly retreated and is approaching the 200SMA (now at 14.57) from the other direction. There are some other notable moving averages in the 14.4-14.9 area including the 100SMA, 50SMA, 60EMA, 90EMA and the lower envelope of the 10-2 Bollinger Band, as well as support levels established by previous VIX spikes. This suggests another 5% downside in VIX before support.



Taking a look at VIX futures (chart below), we went into backwardation for a day on Jan 24 and returned for six more days from Jan 30 through Feb 6. This was the longest string of backwardation we've seen since the the Aug 2011 selloff. The impact that backwardation and rising VIX futures have on the price movement of VIX ETF was made clear as XIV fell 30% from its Jan 22 close to its Feb 5 low. Although XIV has recovered somewhat and is down "only" 17% from Jan 22, it is still at risk for further declines should we see a move back to backwardation (also see "XIV: When a 'Sure Thing' Goes Bad").

This was a relatively mild volatility spike with VIX reaching just beyond its long term average of 19.8. Should this move in VIX continue to be more than just a blip on the radar, XIV could see some major losses. We're now back in a slight contango after Friday with Feb at 15.47 and March at 15.88. Feb VIX futures are 1% above spot VIX, which is a very small premium with six trading days left before Feb VIX futures expire. Typically you can expect VIX and expiring VIX futures to remain pretty well coupled as we approach expiration.




Forecast Review
With the expectation for a more dynamic market in 2014, we've been using the signals from our WRY-10SMA indicator in addition to our Bias forecasting signals to guide us in trading. This provides us with additional signals to help avoid short-term drawdowns. After a choppy and sideways January we saw a move in the VXX Weekly Roll Yield above its 10SMA on January 23rd. Combining this with a confirming MACD signal in the VIX on that same day, we went long VXX, selling a potion on the 24th and the remainder on the 27th to lock in 11% gains. This turned out to be premature as the WRY stayed above its 10SMA for 7 more days and an additional 19% gain in VXX, but I find it's always good to take profits in VXX before they disappear. (Note: we will soon be updating our WRY-10SMA indicator to reduce the amount of signal noise by utilizing exponential moving averages.)


Looking at our Bias forecast over the past six months, the negative bias on VXX has been trending smaller resulting in a more difficult short of VXX.




Our VXX Spike Risk forecasts showed a substantially elevated risk over the last few of weeks rising from 25% up to 70%.



Trading Outlook 
First and foremost, let's respect the fact that the market is moving higher, the VXX bias is back to negative, and the VXX WRY is below its 10SMA. Follow this trend and see how we do with the various levels of resistance in the S&P 500 next week (1810 and 1820). Let's also respect the fact that XIV dropped 30% on a modest 5% pullback of the S&P. We are in a relatively old bull market which is rather complacent and investors are heavily leveraged while shorting volatility is a crowded market. We don't yet know if the emerging market issues from the past 2 weeks were just noise or the start of a real problem. When we hit a real problem somewhere down the line VIX will spike quickly and severely and I, for one, don't want to be heavy on the wrong side of the trade when it does.


Trading Plan
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