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Long Vol?

Written by Paul Amery

  
March 24, 2010 7:07 PM (CET)

With equity market volatility expectations, as measured by the VIX index, bumping along at their lowest level since May 2008, is it time to go “long vol”?

The VIX index measures the implied volatility of a weighted basket of options on the S&P 500 index’s component stocks over the next 30 days. A low VIX means that complacency abounds and the cost of hedging through options is cheap, while a high VIX means that fear besets the market and you’ll have to pay through the nose for any options you buy. It’s a much-used contrarian indicator for the equity market, although its use as a timing tool is open to question.

For example, VIX was stuck in low double figures for much of early 2007. In hindsight, this was a very good sign that trouble was ahead and that the market, collectively, was taking on too much risk, but if you’d gone short at that point you’d almost certainly have been stopped out before equity markets hit their peak in November. Equally, the VIX twin peaks in late 2008 – the two spikes on the chart – didn’t signal the bottom for the equity market, which occurred a few months later (although if you’d bought equities in November 2008 you’d be sitting pretty now).

But whether or not we’re at or close to a peak in the equity markets, there are ways to express a “pure” volatility view without taking a directional bet on share prices.

In addition to the traditional methods of buying options, contracting so-called variance swaps or buying VIX futures, there are now exchange-traded instruments that “package” volatility exposure for you.

iPath launched its VIX short-term (VXX) and medium term (VXZ) futures ETNs in the US early last year, and in Europe in December 2009. While the European versions have yet to attract significant assets, the US ETNs have over US$1.5 billion invested, primarily in VXX.

Inflows to the American versions of these ETNs have been pretty steady, despite their poor performance over the year. VXX has suffered in particular, losing around 80% of its launch value.

The ETN has suffered not just from the decline in “spot” VIX (as measured by the index itself), but also from negative roll yield – exactly the same problem that has beset a number of futures-based commodities products over the last year. Because VXX maintains a 30-day constant maturity in VIX futures, it has to roll one 30th of its futures positions daily into the next monthly contract. As the VIX futures curve has been steeply upward-sloping for much of the last year, there has been a steady cost involved in this roll policy, which has impacted the ETN’s return.

VXZ, which maintains a five month constant maturity, is exposed to a part of the futures curve that is typically “flatter” and so roll costs have not been as significant.

The flipside of this is that you get more bang for your buck in VXX when market volatility expectations change, as the chart below, provided by Barclays Capital, shows.

For every 1% move in VIX itself, you’d expect a 50 basis point move in VXX, but only around a 20 basis point move in VXZ.

These are more traders’ instruments than long-term buy-and-hold investments, given that the roll yield cost can be high during extended periods of low volatility.

There are also the familiar potential risks of ETNs, notably counterparty risk to the issuer, in this case Barclays Bank plc. And the iPath volatility ETNs don’t offer the daily redemption mechanism (which acts to mitigate counterparty credit exposure) that the same firm’s commodity ETNs offer as standard.

However, for investors who are concerned by equity market complacency but who prefer to express such a view by means of a pure volatility instrument (rather than a directional share price bet), these ETNs are worth a look.

 

 




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The views expressed by those blogging are for informational purposes only and should not be construed as a recommendation for any security.

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