The CBOE Volatility Index (VIX) did not see much activity in 2017 and traded at historic lows. That said, the short volatility trade was all the rage last year. Some of the best performing volatility strategies were buying short volatility ETNs, coupled with shorting long volatility ETNs. Volatility, or vol, is often said to have mean-reverting properties. In other words, when volatility is extremely high or extremely low, it tends to move back to the long-term mean level. With vol near historic lows, some might think its time to buy volatility, thinking it could revert back to the mean. However, it could be looked at both ways. If the S&P 500 continues higher, vol would remain low and the short trade could still be profitable.
Ready to learn how to trade volatility? In this post, we will be looking at two exchange-traded products (XIV and TVIX) with exposure to the VIX, allowing traders to play both sides in the short term. The VelocityShares Daily Inverse VIX Short-Term ETN (XIV) provides short exposure to the CBOE Short-Term VIX. On the other hand, the VelocityShares Daily 2X VIX Short-Term ETN (TVIX) provides leveraged exposure to the VIX.
Volatility Trading Strategies
One strategy for trading volatility is too short. In this case, you wouldn’t hold onto the volatility trade for very long; you’d want to get rid of the volatility product quickly, capitalizing on fluctuations in price.
Keep in mind that to trade volatility is risky, especially if you’re shorting. Going long XIV means you’re willing to lose a substantial amount of your investment in the event vol spikes significantly. Now, if you’re bullish on volatility, TVIX could be a good play. However, you should not hold XIV or TVIX over the long term. You may have read what leveraged ETFs are and how they could be highly risky, and we need to constantly emphasize this. Although leveraged and inverse ETNs are risky over the long term, you can confidently consider them in the short term, because this is how they were designed – inverse ETNs/ETFs provide exposure corresponding to -1X their underlying indices, while leveraged ETNs/ETFs amplify the underlying asset’s performance over one day, typically.
XIV and TVIX Explained
XIV and TVIX both track the VIX by holding futures contracts on the CBOE Short-Term (ST) Volatility Index. Let’s start with XIV.
XIV is a great play for those who have a high risk tolerance and believe volatility will remain low. Moreover, XIV is more attractive than outright shorting long volatility products like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) because the loss potential is theoretical unlimited when you’re short. That means if you’re short VXX and vol explodes, you could be in a world of pain. Moreover, this could lead to a short squeeze and push VXX higher. That in mind, if you’re bearish on volatility and believe it’ll remain low or trend lower, you should look to less risky ETNs/ETFs, like XIV.
Since there is no way to directly buy or short the VIX, XIV‘s managers hold front and back month futures contracts on the VIX. For example, in late January, XIV will typically hold futures contracts expiring in February (front month) and March (back month). Take note: XIV does not truly replicate a short on its tracking index. Rather, it seeks to provide one times the inverse of the index on a daily basis. In other words, if the CBOE Short-Term VIX is down 1%, XIV will be up 1%. The opposite is true if the CBOE Short-Term VIX is up 1%.
TVIX, on the other hand, aims to track two times the daily percentage change in the CBOE Short-Term VIX. That means if the CBOE ST VIX is up 2% one day, TVIX should be up around 4%. Conversely, if the index is down 2%, TVIX would be down 4%.
With these ETNs, you could take both sides of the volatility trade over the short term. However, you should never hold XIV and TVIX for extended periods of time.
Don’t Hold These Volatility Products for Extended Periods
Remember, XIV and TVIX aim to only provide investment results corresponding to the CBOE ST VIX’s daily performance. If you hold XIV or TVIX for an extended period of time, the returns will likely differ from your expectations. For example, if the CBOE ST VIX is up 10% in 5 trading days, don’t expect TVIX to be up 20%.
Here’s a look at TVIX and VIX on the daily chart:
If you notice, TVIX has steadily declined over the past year, while VIX was in range and had muted moves. This is a clear example of why you shouldn’t hold TVIX for extended periods because you could lose a substantial amount of your investment.
Even though XIV is not leveraged, you also do not want to hold the ETN for extended periods. By design, these ETFs/ETNs are rebalanced daily, that means the holdings differ day-to-day. Again, that means TVIX and XIV only provide returns corresponding to the one-day performance of their underlying. Similar to TVIX, if vol starts ramping and the markets remain in a high volatility environment, XIV could start to trend lower. Since volatility remained low in 2017, XIV has been on a tear. Here’s a look at the XIV’s daily chart:
When volatility remains low and trends for an extended period, XIV benefits and that’s how some traders banked last year.
Although the short volatility trade has been working, it could eventually come to an end. However, that doesn’t mean you can’t trade volatility. In fact, you might consider TVIX in times of high volatility and XIV in times of low volatility. As you continue learning how to trade volatility index, keep researching these two ETNs. You could play both sides and increase your trading opportunities.
Jeff Bishop is lead trader at Weekly Money Multiplier. He runs short-term trading strategies, using stocks, options and leveraged ETFs.