We have come to the conclusion that being long volatility is a good way to hedge long equity positions. Unfortunately, many of the ways to be long volatility (long straddles, long puts, long put-spreads) can be very expensive to maintain over time due to the time decay of the options. VIX futures provide an interesting way to be long volatility because they allow you to take views on the forward curve of implied volatility. We discussed in the previous post that during low volatility periods, the forward curve on VIX futures is usually very steep. This means that you lose value in your long position as the futures age. This means that we need to be very diligent as far as how we place a trade with VIX futures as the maturity of the futures contract will have a very real and significant impact on the carrying cost of the hedge. Trading in futures also means that we are placing bets on the VIX at forward periods in time. If we trade an April VIX futures contract today (on April 1) we are placing a bet on implied volatility between April 15 (expiration) and May 15th whereas the spot VIX is looking at April 1st through April 30th.
In addition to the curvature of the forward VIX implied volatility curve, we need to address the fact that many investors either lack the ability or the confidence to trade directly in the VIX futures market. Thanks to the innovation of our investment banker friends, we can easily access these markets through two exchange traded notes (ETN’s). The big difference between ETN’s and ETF’s is that the ETN is backed by the issuing entity. This means that if the issuer (in this case Barclays) goes bankrupt you are sitting in line with the senior, unsecured creditors. Ignoring the subtle difference, these iPath ETN’s provide a great way for investors to access implied volatility through underlying investments in VIX futures.
The iPath S&P 500 VIX Short-Term Futures (VXX) maintains a rolling long position in the first and second month VIX futures contracts. The iPath S&P 500 VIX Mid-Term Futres (VXZ) holds a rolling position in the fourth to seventh month contracts. The takeaway here is that the choice between VXX and VXZ places your volatility bet on different places of the VIX futures curve and it means that your position will be more or less tied to the VIX spot rate. The second point is important because VIX futures become less correlated to the spot VIX index as you move further out in expirations. The general profile looks like:
As with everything in life, there is a give and take. By investing further out on the curve, we do not capture as much of the movements of the VIX spot index. On the flip side, by investing further out on the curve, we lose less as the futures contract ages. Again, we add a further dimension of complexity to our trading habits but very useful information. This says to me that if you want to place a bet that volatility is going to rise or fall dramatically in the near future, then your best place to make that bet is with VXX. If you want to hedge your portfolio over a longer period of time, then you are better off using VXZ because it has a slower decay that will not eat into your long-term equity returns nearly as much.
Now that we have our equity hedging framed out, it is interesting to consider the interactions of the two contracts. If we look again at the curve and the decay of the contracts over time:
This tells you that a June futures contracts decay by 15.97% over 2 months while a September futures contracts decay by 2.17% over the same 2 months. Consider this the cost of holding the long position over time. This is important because we can think about VIX futures trades much like we think about calendar spreads in the options world. In a calendar spread you buy a longer dated option and sell a short dated option. You hope that the short-dated option decays (loses value) quicker than the long-dated option. In addition you hope that your purchased long-dated option covers you against adverse movements on the short position in the short-dated options. With VIX futures, we can make a similar bet. By being long VXZ, it should cover us from being short VXX. In addition, the short VXX position should gain more value as it decays than the long VXZ position loses over the same time period. The key is to find the correct ratio between the two investments. Since the Beta of VXX is about .5 and the beta of VXZ is a bit above .2, you could sell 1 share of VXX while purchasing 2 shares of VXZ as a long-term strategy to capture the fast time decay of shorter dated VIX futures.