Contango: The Beast Of Burden For VIX-Leveraged Buyers

They keep pushing and suggesting to traders the buying of volatility as a form of portfolio protection. Be it on Bloomberg or CNBC, the mantra continues in spite of the complacency that has served to underline the Volatility S&P 500 (VIX ) over the last couple of months. Unfortunately, when the media outlets discuss buying volatility they do little in the way of detailing how or why volatility should be bought short of saying, “protect your portfolio”. 

Most individual traders don’t realize the reality that ensues after choosing to buy volatility in most form factors, be it directly or through the various VIX-leveraged ETFs and ETNs. It’s not just that you, the trader, are buying an instrument that forces timing a volatility event, but it also forces greatly timing an exit of that instrument and before it decays in price once again. This is what the media doesn’t explain, at all! Furthermore, just because volatility is forecasted to increase in the near-term by the media, analysts and economists, that doesn’t necessarily mean an individual trader can or will benefit from buying VIX and VIX-leveraged instruments. 

Last week, unbeknownst to many who chose to participate in ProShares Ultra VIX Short-Term Futures ETF (UVXY), ProShares Short VIX Short-Term Futures ETF (SVXY) or like instruments, even as volatility increased for the week, these ETFs didn’t support the hedge against volatility.  That’s right, the VIX climbed nearly 4% last week and if you bought shares of UVXY thinking they would increase in value due to their VIX leverage, you were found wanting for profits as shares declined to new all-time trading lows.  If this seems unusual to you because you thought UVXY was a good hedging strategy it’s likely because one of its construction variables wasn’t considered, contango.

In a recent article I described the nullifying effect contango can have on volatility post achieving 5% for a VIX ETF like UVXY.  In Contango Spreads Across ProShares Ultra VIX Short-Term Futures ETF (UVXY), I offer the following: 

Contango is the defined condition occurring when VIX futures that underlie these ETFs are in price/time arrangement and as such contribute to the share price decay. When the level of contango increases it also exacerbates price declines, even during periods where the VIX actually rises. In more laymen terms, when contango takes over a share price death spiral takes place in the VIX leveraged ETF until the share price exhibits a reset. The reset occurs with an authorized reverse split.

When this article was published, shares of UVXY were trading above $12 a share. Contango has increased since this time and has been above 10% over the last 15 trading days, last week achieving its highest levels in recent trading months just above 17 percent. Shares of UVXY, in spite of greater volatility last week, traded lower by roughly 3%. So for those looking to hedge against volatility by utilizing VIX-leveraged ETFs, make sure you understand their composition and what level of contango exists before doing so.

For those traders buying UVXY hoping to hedge against the possibility of greater volatility in the future, it would behoove them to understand that UVXY does not own VIX, but rather VIX futures contracts. As such it does not matter that the VIX rises on a particular day. What really matters is the VIX future, a contract that expires on a set date each month. It’s not that buying volatility as a hedge can’t work in favor of the trader, but rather the timing has a magnified determination in the matter. Moreover, why play the “market timing” game?

Volatility and VIX-leveraged instruments were not introduced to be used from the long side. The nature of volatility is that of exhibiting longer periods of complacency than it does outsized fear/volatility. “But what about the financial crisis and what if you had bought the VIX during that time”? This is a question often put forth by those who fear and don’t understand shorting the VIX and VIX-leveraged instruments, but it pretty perfectly points toward proving the performance of the VIX.  How’s that for an alliteration of profound perfection? 

The vast majority of the equity market declines came in just a few short months whereas the rebound from that period has lasted roughly 7 years.  A few short months versus 7 years. That’s how complacent the market is and how it is reflected through the VIX, always.  If it weren’t exhibited this way, there likely would not be a market to participate with capital.  Nobody is putting their money into a state of constant fear and uncertainty, constant being the key word.

UVXY and like instruments have seen large buying volume outright and through options over the last couple of weeks. As many traders anticipate Dow 20,000 fortifying 2016 capital gains, these market participants also believe or expect Dow 20K to elicit a market decline from such a level. It’s for this, among other reasons, traders have been buying “protection” against the potential for a return of volatility in the markets near-term. But as I have said for many years, complacency is the greatest value to markets and can persist for longer than most traders can realize or rationalize. Rationalizing that volatility should have presented itself is easy enough and many traders have convinced themselves that the OPEC decision, Italian Vote, U.S. Elections, S&P 500 trading at 20X, FOMC raising rates all should have elicited greater volatility in the markets and yet all that has occurred has been greater complacency. Dow 20K and S&P 500 PE trading levels still remain standing to benefit from a resurgence of volatility. But for all the VIX buyers over the last 30 days and as UVXY has expressed heightened contango, fighting contango is the equivalent of…well the picture below expresses the sentiment better than I can articulate it.

It’s actually a worse decision than described in the photograph to have bought certain VIX-leveraged ETFs recently as contango virtually guaranteed losses to long positions. The far better option, should one have believed volatility and a downturn in the markets was on the horizon, would have been to short SPDR S&P 500 Trust ETF (SPY). The SPY isn’t plagued by a variable such as contango. It’s unfortunate that the media doesn’t articulate the underlying problems with shorting instruments like UVXY or report on the losses from like hedging strategies, but nonetheless…

Contango is a beast! It’s unfortunate that more media outlets don’t offer greater commentary on the subject matter and even more unfortunate that amateur market participants are encouraged to publish articles on the VIX and VIX-leveraged instruments.  One such article which completely avoids discussing contango while touting a belief that volatility will surge in early 2017 was published by Seeking Alpha last week.  Brandon Dempster’s, “Volatility Will Come Back In A Big Way”, suggests that alongside the return in volatility will be a spike in VIX-leveraged instruments like VXX and TVIX.  But these instruments don’t track the VIX they own VIX futures contracts and as such don’t correlate 1-to-1 as the article would have one assume. VIX –leveraged instruments are not for amateur participation either as authors or traders and beg for greater due diligence.

In closing, as it pertains to the VIX and instruments like UVXY, TVIX and VXX , know how they are constructed and how they were designed to behave in the market.  Buying instruments requires great timing and as noted in their respective S-1s should not be used for more than day trades. I’ve been a long-term, short investor in shares of UVXY since 2012, holding a core position while shorting most every spike in shares over the years.  Most recently I lowered my core short ownership to represent roughly 20% of my total portfolio holdings. My annual strategy has always been to increase my short position in the new year and during spikes, then taking profits when shares resume their downtrend.  For much of the year I will dedicate greater than 40% of my portfolio capital to UVXY and TVIX and by year’s end reduce my exposure thus capturing the greatest of profits from their constant decay. This coming new year may be somewhat different given what may lay ahead for market participants and as such I’m not affixed to my former/current strategy, but pliable to market conditions. 

Disclosure: I am long FIT.

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