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In the Dec. 16, 2013 issue of Forbes magazine, the editors offer their list of 365 Ways To Get Rich with their 2014 Investment Guide.  #100 on the list is this suggestion: Profit from stock market volatility: Buy into a VIX futures fund and use wild, seemingly irrational swings as buying opportunities.

The most commonly known VIX futures fund is VXX, the iPath SP500 VIX Short-Term Futures ETN .  And while it might be a useful trading vehicle for someone looking to trade extremely short term moves, it is a  horrible idea for investors .

The share price history of VXX has a terribly negative bias, and it has ever since it debuted back in 2009.  VXX ended 2013 at a price of 42.55 (unlike SPY or GLD, VXX’s numerical price is not directly related to the numerical value of the VIX).  That is down huge from its March 2, 2009 high of 7449, when we adjust for 3 separate 1 for 4 reverse splits.

This persistent negative bias has to do with the nature of the VIX futures contracts that VXX invests in.  Most of the time, those futures contracts have a contango to their pricing, meaning that the price is higher the farther out into the future you go for a contract’s expiration.

The table at right shows the closing prices for VIX futures as of Dec. 31, 2013, extending out through the September 2014 contract (the furthest one currently open).  You can see that all of the contracts are priced higher than the spot VIX Index, and the further out you go, the greater that premium is.

As of this writing, VXX currently has its holdings divided between the January (F4) and February (G4) 2014 VIX futures contracts.  As the January contract nears expiration, the folks at iPath will have to replace it with the March contract (H4), and presumably at a higher price.  That price premium will then decay back down toward where the spot VIX is as the contract nears expiration.  So VXX shareholders are continuously being victimized by the roll to later expiration month contracts, with that ETN buying higher and then selling lower, and repeating.  That explains why the VXX’s long term performance has been so awful.

That does not mean VXX cannot be used for very short trading periods, when a rising VIX pushes up the prices of its futures contracts, and when the effect of the roll to the later contracts is not an important factor.  But for  investors with a longer time horizon, owning VXX can be a hedge against a portfolio ever making any money.

Interestingly, just as the roll to later contract months can hurt investors in VXX, that same factor can help others.  XIV is an ETN sponsored by VelocityShares which is designed to move inversely to the VIX.  So if the stock market were to be making a short term  price bottom, with the spot VIX up at a high level, then a trader could own shares of XIV to play the possibility of the VIX coming back down.  In other words, with a long position in XIV, a trader can be short the VIX.

And unlike VXX, which gets hurt by the roll to later contract months, XIV gets the benefit of that roll by shorting VIX futures at a higher price, and then harvesting the benefit of the decay as each contract’s price moves back closer to the level of the spot VIX Index.  It is for that reason that XIV has a positive bias relative to what the actual VIX does.

You can see that XIV does move inversely to the VIX in the short run, and the magnitude of those movements can be quite violent.  But the longer term trend is decidedly upward, owing to the profit factor from harvesting the contango by shorting VIX futures contracts at higher prices further into the future.

Because the VIX has a reliably inverse relationship to the SP500, and because the XIV moves inversely to the VIX, many traders have figured out that they can use XIV as a leveraged proxy for the SP500.  Since January 2011, the daily percentage changes in the SP500 and XIV have a correlation coefficient of +0.82, and a beta (leverage factor) of 3.19.  In other words, if the SP500 were to move up or down by 1%, then the expectation would be that XIV would move by 3.19% in that same direction.  It does not always work out perfectly that way every day, but on average that is their relationship.

And in addition, XIV gets a performance enhancement by harvesting the contango as mentioned above.  Here is a chart comparing the SP500 to XIV for the past 3 years:

Since January 2011, the SP500 has grown 45%, but XIV has grown 178%, adding up to 33 percentage points of alpha over that 3-year period.  It has not been a very smooth advance though, as some significant drawdowns have occurred over that period.  Most notably, the big drop in 2011 took XIV down 74% from its high that year to its low.  There were not enough months of harvesting contango to make up for the negative effects on XIV from that big rise in the VIX.  So investors and traders really can get hurtBut in a period of a rising stock market, traders who can enter and exit efficiently and who can stomach the higher beta may find the XIV a useful trading vehicle, turning the problem of the roll to higher price futures contracts to their advantage.   Please note. I am not advocating that anyone adopt such a trading scheme, and I never recommend the use of any individual securities or trading plans.  My purpose here is to help educate readers about how these products work.

Tom McClellan

Sherman and Marian’s son Tom McClellan has done extensive analytical spreadsheet development for the stock and commodities markets, including the synthesizing of the four-year Presidential Cycle Pattern. He has fine tuned the rules for interrelationships between financial markets to provide leading indications for important market and economic data.

’ In April 1995 they launched their newsletter, The McClellan Market Report, an 8 page report covering the stock, bond, and gold markets, which is published twice a month. They utilize the unique indicators they have developed to present their view of the market’s structure as well as their forecasts for future trend direction and the timing of turning points. A Daily Edition was added in February 1998 to give subscribers daily updates on their indicators and also provide market position indications for stocks, bonds and gold. Their subscribers range from individual investors to professional fund managers. Tom serves as editor of both publications, and runs the newsletter business from its location in Lakewood, WA.