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Should you short the VIX?

August 5th, 2011 · No Comments

After all, it’s mean reversing..


The VIX is above 30 right now. That’s way above its long-term average (about 20). We know it’s mean reversing, so eventually it will get back to 20 or even below that. So is shorting it a good idea, and if yes, how do we go about it?

First, you can’t trade the VIX directly. You can either buy futures, or a host of ETF and ETN related products. Not to complicate things unnecessary, we’ll concentrate on two of them, VXX (the oldest VIX ETF) and TVIX, the relatively new daily 2X VIX ETF. TVIX gives you approximately twice the bang for your buck compared to VXX.

Now, shorting them is risky:

  • If the markets melt down, these ETF’s (TVIX in particular) can go much higher
  • So you should either have sufficient margin, or be prepared to take losses when you’re timing turns out to be wrong

You can see the last three years of the VIX here:

X  (Room to avoid the add at the right)

X

X

X

X

X

X

You’re caught out badly if this sell-off turns out to be of the 2008 variety. However, even then the VIX will return back to earth but you must be able to sit it out (or take losses earlier).

But there is another force that can work to your advantage. Both VXX and TVIX have maturities of exactly one month, meaning that every day they have to exchange a certain number of VIX futures expiring the first coming month for those of the month after that.

If the latter are more expensive (a situation known as ‘contango‘), your short gets an extra boost by the churn (replacing cheaper futures for more expansive ones). For most of the history, this has been the case. The result over time of this churn is quite interesting:

Unfortunately, even VXX is not that old a product (it started trading at the end of January 2009, mostly after the crash). But you see that when markets are rising, shorting VXX is highly profitable (although one has to realize this graph, since it starts almost at the bottom of the 2009 bear market, paints too rosy a picture).

The TVIX is a much more recent instrument, but its graph is also instructive:

Realize two things:

  1. In a market crash, both will increase much more, we cannot stress that enough
  2. VIX futures are now in a situation called backwardation, second month futures are actually cheaper than the first month, this actually inflates both VXX and TVIX at the moment.

If you think we’re not heading for a 2008 repeat (or worse), a small short position can be highly profitable. But once again, have sufficient margin for these things to go much higher (if you’re wrong) or be prepared to sell at a loss.

Alternatively, you can wait for a market turn and/or ECB buying of Italian bonds. Shorting rising knives can be as dangerous as catching falling ones. You could also hedge with options on VIX futures, although these are pretty dud products (because of the mean-reversing nature of the VIX, movement offurther out maturities is pretty muted).

If you can afford to hold on to them, you eventually get your money back with interest though..

Tags: vix