Volatility as an Asset Class

So, what was the best performing asset class today?  Stocks were tossed into the campfire, while 10-year U.S. Treasuries were up about 1.6% and gold gained 3.3%.

Take a look at the CBOE Volatility Index – otherwise known as the VIX.  This literally exploded upwards by 50% today, from 32 to 48.    Volatility is currently at the same level as when the Greek debt crisis first peaked in 2010.

The problem is that very few people know how to own (much less trade)  volatility.

The VIX is a measurement of volatility and uncertainty as measured by options prices.  It’s also known as the “Panic Index”.  Yes, people are panicking right now.  Anything above a level of 30 is considered extreme.  (Thank goodness we have our S&P 500 hedges in place, right?)

Volatility as an asset class has the potential to be a super-diversifier.  In 2008, when stocks lost a third of their value, real estate collapsed and many bond funds had double digit percentage losses.  Meanwhile, the VIX index increased five-fold, from 16 to 80.

In theory, if a person put 1/10th of their portfolio into the VIX index in 2008 and sold at the peak, they could have made a net profit even if they had invested  other 9/10ths  of the portfolio in stocks.

At this point, it makes sense to ask the question of how it might be possible to own volatility. You could write options, or you could buy futures contracts.  Most people would think about owning a volatility ETN (exchange-traded note), such as the Barclays iPath S&P 500 VIX ETN (ticker: VXX).

Here’s the problem:  the VXX is a crap-tastic investment.  While the VIX gained 50% today, VXX advanced only 14.1%.     It gets worse than that… much worse.  On a year-to date basis VIX index has gained 172%, while the VXX is not yet at breakeven.

Quite simply, the VXX has the largest tracking error of any index vehicle that I have ever seen. This is not meant to disparage the folks at Barclays;  it has everything to do with the term structure of volatility futures contracts.  (Without getting into the details, that means that people generally have expectations that volality will be higher in the future than it is today. And for the most part, people are often disappointed.)

So, the next great trade is not necessarily a bet for or against the market.  It could be a bet against volatility, in the form of the VelocityShares Daily Inverse VIX Short-Term ETN (ticker:  XIV).  This is supposed to moved in the opposite direction of the VXX and normally benefits from the term structure of volatility futures. As of July 1st, XIV was up 58% for the year.   Since then, performance has not been great. XIV is down 47% and could lose more if volatility continues to go up.    (This puts it at -16% for the year.)

The really interesting thing about this trade is that we don’t need to have a bounce in the stock market for volatility to go down.  We just need to see stocks move downward a little more slowly.

Kids, don’t try this at home.  I haven’t done anything with this trade yet.  Right now, I’m just watching the set-up.   It is a high risk-trade that I will eventually do with a small fraction of my portfolio capital.

This is not an investment recommendation of any sort.  One of the goals of this blog is to help people think strategically.  Buy-and-hold hasn’t worked in a decade or more.  Thinking like a trader has saved my portfolio more than once.

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5 Responses to Volatility as an Asset Class

  1. AET says:

    Very interesting post – certainly something to think about. One often hear’s of the VIX, but this is the first discussion I’ve heard on how to possible trade it.

  2. Jim Lee says:

    Thanks, it took me about a year to figure this one out…

  3. If there was a way to own Volatility without exposure to time decay, you’d be Midas.

    The ETFs are crap because the futures lag the statistic around the expiring options.

    I’ve tried buying puts speculatively and hedging by selling shorter-term puts, I actually owned an August 77 Put on IWM last month, and a May 70 Put on IWM back before the Flash crash, in both cases I sold out early because I was skittish about the slow death of theta decay. And that’s funny.

    Have you run any data on trading strategies of buying OTM puts or Straddles in order to try and catch explosions in implied volatility? I’d bet you’d have difficulty finding positive expectancy. Fading volatility explosions toward mean-reversion, on the other hand, I suspect does have some statistical edge.

    • Jim Lee says:

      That’s pretty much what I’m doing here – fading volality explosions towards mean-reversion. As far as the options activity is concerned, I’ve only ever made money by writing them. So, writing an inverse straddle would be another way of playing this…

  4. Uncle G says:

    Uncle G…good read.Market way too volatile , and trading too complex for me the average Joe to think I could have any idea of what I’m doing..I’m out.

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