Volatility Products: Analyzing Sensitivity
Apr 25, 2019
Although it may seem hard to believe, the VIX slid beneath 13 right before Tax Day in the USA, and closed April 14th trading at 12 and change. And just before Easter, it was threatening to close with an 11-handle.
So much for all that drama swirling around the "trade war," it would seem.
Simply stated, the VIX has gotten decimated since those dramatic days in November and December of last year when it seemed like the bottom might finally fall out of what has become the longest bull run in market history.
And while snow may have fallen not long ago in some parts of the USA, it's even starting to feel like the financial markets have already entered a sleepy, summer trading phase. Or at least it's being priced that way.
So what can we learn from the last several months of trading? If you haven't reviewed a previous episode focused on the recent pattern observed in VIX - "Cluster, Pop, Revert" - then we recommend doing so when your schedule allows.
To supplement those findings, the Market Measures team recently conducted new research on four different volatility products which evaluated their relative sensitivity to movement in the S&P 500. We think the findings will not only interest you, but possibly help you refine your approach going forward.
On the episode, historical data in VIX, VXXB, UVXY, and SVXY is analyzed with the intent of better understanding how each has reacted to movement (up or down) in the S&P 500 recently. Before jumping into the results, let’s first take a quick look at an overview of each one:
VIX: This is the famous (or infamous) CBOE Volatility Index which represents the market's expectation of 30-day forward-looking volatility based on the inputs of S&P 500 options. It is commonly believed to provide a measurement of market risk and investor sentiment.
VXXB: VXX was replaced by VXXB after VXX expired in 2018. The VXXB is an Exchange-Traded Note (ETN) that seeks to replicate the returns of a market benchmark - in this case that benchmark is the VIX. That means the VXX acts similar to the VIX, but not exactly the same. VXXB can be bought, sold, or sold short like a stock, which the VIX cannot. VXXB also has listed options. VXXB uses VIX futures to pursue its goal of replicating the return of the VIX. To make things a little confusing, the VXXB will change tickers and be renamed VXX in early May 2019 - but only the ticker will change.
UVXY: While the UVXY isn't the same as the VXXB, there are some similarities. As with the VXXB, the UVXY seeks to replicate the return of the VIX, but in this case its goal is 1.5x the VIX (the VXXB would be 1x the VIX). The fact that UVXY seeks a 1.5x return is a good indicator of its true self - a leveraged Exchange-Traded Fund (ETF). The method by which the UVXY achieves its 1.5x mandate is by purchasing extra VIX futures (as compared to VXXB) and also using margin (i.e. credit). As with any investment that involves credit, that dynamic means there are added complications when trading UVXY, and traders should research the product thoroughly before getting involved. The UVXY can be bought, sold, or sold short like a stock, and also has listed options.
SVXY: While the VXXB (an ETN) and UVXY (leveraged ETF) are designed to replicate the returns of the VIX (1x and 1.5x, respectively), the SVXY is what's known as an inverse ETF. In practice, that means the SVXY is intended to move in the opposite direction of the VIX - to the tune of -0.5x. Generally speaking, the SVXY should therefore increase when volatility falls, and decrease when volatility increases. Like VXXB and UVXY, the SVXY can be bought, sold, or sold short like a stock, and also has listed options.
The above information should serve only as an overview of these four volatility products. Prior to deploying a position in any of the above products, traders should conduct extensive research on the nature and behavior of them to ensure they match their outlook and risk profile - as with any potential investment product/strategy/structure.
Now that we've identified the four volatility products covered on Market Measures, we can return to the matter at hand - highlighting new tastytrade research on the relative sensitivity of these products to movement in the S&P 500.
The graph below highlights recent movement in each of the 4 volatility products over the last seven (or so) months. What's of particular interest over this span is the period when volatility picked up at the end of 2018. As highlighted in the large red square in the chart below, it's easy to see how each of the four responded to that particular pop in volatility:
Taking a quick look at the individual lines of data in the above graph, we can see that the behavior of movement in each product does match (to some degree) our expectation.
Due to frequency of selloffs in equities during this period, it's not surprising to see that the VIX launched higher - the options of the S&P were clearly pricing in a heightened risk environment.
What is a little surprising is the degree to which the VXXB and UVXY lagged the VIX, especially since they are intended to "replicate" its return (especially the UVXY which seeks 1.5x the return). However, an understanding of the mechanics of these products does help to explain the above behavior.
VXXB and UVXY use VIX futures to achieve their mandate, which means the products are constantly required to roll their positions into the new VIX futures month(s) when the old ones expire. As a result, this means the fund managers of those products are often forced to sell the lower priced VIX future, while simultaneously purchasing the higher-priced future VIX - because uncertainty is often priced "richer" the longer one goes out in time.
It's these realities (selling low and buying high) that produce the "drag" effect illustrated in the chart above, and help explain why VXXB and UVXY were more muted in response to the market chaos.
Looking at SVXY, we do see that it performed somewhat as expected - in the sense that it should move in the opposite direction of the VIX. And given it's target of -0.5x the VIX (i.e. reduced exposure) the less jagged behavior shown above makes sense.
Now that we have additional insight on how these four volatility products moved in the most recent VIX explosion, we can look a little more closely at their "average behavior," to see if any helpful information emerges. In order to produce the data for this examination, the Market Measures team utilized historical data in each going back to 2012.
The findings from this exercise were somewhat similar to what was observed in the graph shown above - and possibly match even more closely with our original expectations.
The first slide below summarizes how each of the 4 products moved on average during down days in the S&P 500 since 2012. The second slide provides a look at the same data on up days in the S&P 500 over the same time frame.
What's most telling in the "average" data shown above is how our expectation of the UVXY is confirmed in both slides. No matter whether it was an up or down day, the UVXY in both cases moved more "on average" than the VXXB - proving that it does indeed move to a greater degree with the VIX than the VXXB (the 1.5x mandate illustrated).
The last exercise on this episode of Market Measures was to analyze the pricing of the options in each of the four products to evaluate whether any attractive opportunities existed based on this data. While we think it's worth your time to review the complete episode focusing on "The Sensitivity of Volatility Products," a sneak peak of the results suggests that the options market somewhat efficiently prices the options of these products - meaning arbitrage between the four isn't *typically* attractive, and that the sensitivity of each is taken into account in the options markets.
If you want to learn more about the VIX, VXXB, UVXY, or SVXY, additional information can also be found using the search functionality on the tastytrade homepage.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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