Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 18 May 2017 at 10:00 GMT

Why long volatility is such a painful trade — #SaxoStrats

Head of Equity Strategy / Saxo Bank
  • Volatility trading increasingly popular
  • Understanding nature of VIX ETFs is key
  • Many traders now long volatility

Traders have grown enamoured of the long volatility stance of late, 
but the VIX is a complicated beast. Photo: Shutterstock

By Peter Garnry

Volatility is the new hottest trading instrument with many participants across both professional and retail investors. The VXX ETF (long front-end volatility), in fact, is one of the most traded instruments among retail investors. But how does volatility work?

Derivative squared

Let's start with the basics. The center of it all is the VIX index which was developed by Menachem Brenner and Dan Galai. The VIX (spot) measures the expected annualised change in the S&P 500 over the next 30 days based on S&P 500 options, also called the implied volatility. 

The VIX is usually traded through options, futures, or ETFs which again are derivatives. So volatility trading is basically derivatives trading on derivatives. There is nothing fungible behind it, as is the case with, say, oil futures.

VIX spot weekly prices since 2004
VIX Index

The VIX spot is a real-time calculated index based on the S&P 500 options and cannot be traded. Futures on the VIX (term structure) are just like on Brent crude; they represent a fixed price at a fixed expiry date. So what does that mean?

If you look at the term structure on May 16, spot was trading around 10.6 which is significantly below the historical average around 19.4. Most investors and traders these days believe that implied volatility is too low and must go higher. What comes to mind, then, is to be long volatility. 

But unlike cash stocks, you cannot buy the spot so you enter a trade that reflects your expectations of future volatility. Let's say that you believe volatility will be much higher at the end of the year, so you buy the VIX December futures contract at around 16.4. How do you make money on this trade?

Well volatility (VIX spot) has to be above 16.4 at the futures expiry for your trade to have made a gain... so a whopping 55% jump in volatility before you make any money. An upward-sloping term structure is called contango and basically means that being long the futures contract requires that underlying spot ends up above. The steeper the term structure, the higher the change has to be for you to make a gain.

Yesterday's massive jump in the VIX index caused an interesting change to the term structure. As you can see on the chart below, the spot is now above the May futures contract (called backwardation) whereas the day before (May 16) the term structure was upward-sloping at all points. How can we interpret the shape of the term structure in the front end? Well, a straightforward interpretation is that traders are expecting this jump in volatility to be short-lived and fall back by the end of May.

If an investor believes that volatility will stay unchanged at the current spot because the political crisis in the US will cause contagion risk in financial markets, then buying the May futures contract at 12.2 makes sense. If the spot is unchanged in two weeks, the trade makes the difference between the future spot of 15.8 and your futures contract entry at 12.2.

Most of the time, however, the term structure is in contango and realised volatility is below implied volatility at future dates. That means that investors being long volatility will permanently lose money on the futures contracts because they pay a too high price on long volatility (which for many investors is essentially a hedge). 

This revelation takes us to ETFs and where the danger lies for retail investors wanting to be long volatility...

VIX term structure on May 16 and 17
VIX futures

Long volatility is about timing

ETFs are another derivative as investors own a vehicle that in the case of volatility owns derivatives (futures) on an underlying derivative (VIX index). ETFs are popular because they take the complexity out of the trade. Retail investors do not have to understand futures to get exposure to volatility... but that is a big misconception. Understanding the VIX term structure in the futures market is key to understanding the risks in volatility ETFs. 

One of the most popular ETFs for being long volatility is the VXX:arcx (see chart below). This ETF is constantly long the front end of the term structure, so the ETF constantly rolls its long position in short-term VIX futures. As a result, it does not track the performance of the VIX index because it's a spot index. The quote below is from the ETF provider's own website:

The value of your ETNs will be linked to the value of the underlying index, and your ability to benefit from any rise or fall in the level of the VIX Index is limited. The index underlying your ETNs is based upon holding a rolling long position in futures on the VIX Index. These futures will not necessarily track the performance of the VIX Index. Your ETNs may not benefit from increases in the level of the VIX Index because such increases will not necessarily cause the level of VIX Index futures to rise. Accordingly, a hypothetical investment that was linked directly to the VIX Index could generate a higher return than your investment in the ETNs. (

As we stated earlier, the future realised volatility is often below the implied volatility and because the term structure is in contango, rolling the front end futures contracts will cause frequent losses which is also evident in the chart below. This is what "negative carry" (as it is called) looks like. It constantly costs something to have this position. The real life analogy is your home insurance. It costs you something every year but when the disaster hits you have protection.

Investors being permanently long volatility will see their capital diminish over time. It's inevitable and thus being long volatility is all about timing and short time horizons. The ETF is an expensive way to get long volatility exposure because on top of the negative roll yield (the term used when rolling long futures gives you a negative yield), you also pay an expense ratio to the ETF provider. Therefore, it should be used with a short and not a long horizon.

iPath S&P 500 VIX short-term futures ETN (VXX:arcx)
VXX weekly prices
Source: Saxo Bank 

The opposite trade is to be constantly short volatility and reap the insurance premium embedded in the volatility market. The most popular instrument for this is the XIV:xnas (see chart below). 

Being short VIX futures provides a positive roll yield and a positive carry which means that the performance will always go up over the long run. However, it comes with major drawdowns as jumps in volatility cause major losses on the short futures positions.

VelocityShares daily inverse VIX short-term ETN (XIV:xnas)
XIV weekly prices
Source: Saxo Bank 

— Edited by Michael McKenna

Peter Garnry is head of equity strategy at Saxo Bank
Liam Conroy Liam Conroy
Great article Peter
ozgur hatipoglu ozgur hatipoglu
Great article. Many will be enlightened. thanks Peter!
ChristianK ChristianK
Very good article. I have learned this lesson the hard way myself...
Cat Cat
A very useful explanation. Thanks for the detail.
Alan M Alan M
VSTOXX mini futures are a great way to get exposure to volatility, low margin and trading costs also
Georgio Stoev Georgio Stoev
Good highlight Pete. As always there's a fear of the unknown, like anything in life take time to investigate before you move in. VIX and VIX derivatives are better suited for professionals or seasoned, short-term traders. Sometimes it make sense to use VIX options/futures to hedge in the market place, others to use options on the cash index (SPX), depends.
Market Predator Market Predator
@Peter: great stuff and now because of "political tension VOL spike" (I believe only temporary) really on-topic. Perfect! 😜
Peter Garnry Peter Garnry
Just some quick changes to some of the details. VXX etc. are obviously ETNs and not ETFs. I write "...and realised volatility is below implied volatility at future dates" - should be that VIX spot often ends up below the futures price.
rafal171271 rafal171271
Was there any special reason to diasble possiblity to short VXX Cfd ?


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