Posted inLatest news

How to make money from volatility trading

2016 700 US dollar Sign with Green ZigZag Arrow

Several ETFs replicating the VIX index have been launched since VIX options started trading on the Chicago Board Options Exchange (CBOE) in 2004. But they have all steadily lost money. Total losses for Europe-listed VIX ETFs vary between 86% and 98% since they were launched 2011/12. Even over the past few months, while volatility has barely moved, investors still have lost a lot of money. So why is that?

Basically, VIX ETFs function in quite a similar way as commodity ETFs. The VIX volatility index is a measurement of the implied volatility of S&P 500 index options, and investors can bet on volatility to rise or fall by buying or selling VIX futures.

This means buying the VIX is always going to be a losing strategy on the long term, said Matt Dougan, CEO of Inside ETFs, at the Inside ETFs Europe conference in London this week. As futures are typically short-dated, investors will have to roll these over continuously, constantly racking up transaction costs in the process.

Contango

But this still doesn’t explain the sheer drop of the price of the VIX over time. The reason VIX ETFs continue to heavily trade downwards even though volatility stays pretty constant (the ProShares VIX Short-Term Futures ETF is down 70% over the past year, compared to the official CBOE VIX index’s loss of 38%) is that the VIX has been trading in contango for the past few years, as the market consensus is that volatility will go up at some point.

This means VIX ETFs must buy more expensive longer-dated contracts while selling cheaper short-dated ones, effectively buying high and selling low. Over time, this creates a downward pressure on the ETF’s price.

Therefore, “VIX ETFs are a real long-term wealth destroyer,” said Dougan, adding the maximum holding period of a VIX ETF is about five days.

And you should only buy it when you think a spike in volatility could be imminent. Most VIX ETFs have only made positive monthly returns in about one in every four months over the past three years, according to Financial Express data.

Go short, young man

But there still is a way to make good money on volatility trading: the only thing you need to do is to make your enemy your friend by shorting the VIX rather than buying it. This would turn the “wealth destroyer” of contango into a “wealth creator” of backwardation. And there is a product for this: the VelocityShares – Daily Inverse VIX Medium Term has delivered a 77% return over the past year. This contrasts with a return of -70% for the aforementioned ProShares VIX Short-Term Futures ETF.

The question is, though, whether you should want to pursue a risk-on trade like this. If volatility increases, which usually coincides with an equity market correction, you risk losing a lot of money. During the last major market correction in early 2016, the VelocityShares – Daily Inverse VIX Medium Term slumped 16.5%.

Part of the Bonhill Group.