Trade of the Day: iPath S&P 500 Dynamic VIX ETN (XVZ)

More popular VIX ETNs like VXX can actually defeat the purpose of a long volatility strategy

   

Recommendation: The recent decline in iPath S&P 500 Dynamic VIX ETN (NYSE:XVZ) may provide a value play to hedge against volatility risk. We recommend buying momentum when XVZ crosses back above $47 per share.

Challenges of Long Volatility

The last couple of years have been brutal for almost all long volatility strategies. This, of course, is the Fed’s intent: to instill confidence and suppress volatility through liquidity.

The ideal long volatility strategy treads water during normal periods while staying exposed to potential large moves in the market. When the market experiences “black swan” events, the value of these options skyrockets. In reality, virtually any long volatility strategy will suffer when volatility is depressed. When the market trends upward or sideways for long periods of time, the continual premium purchasing erodes portfolio value.

12 20 12 1 300x170 Trade of the Day: iPath S&P 500 Dynamic VIX ETN (XVZ)
Click to Enlarge
The idea of including a long volatility component in one’s portfolio is extremely attractive. But as always, the devil is in the details.


To get an idea, let’s look at a popular long volatility ETN: the iPath S&P 500 VIX Short Term Futures TM ETN (NYSE:VXX). Like most of its cousins, VXX is derived from the VIX. It is constructed from a rolling long position in the two front month VIX futures contracts.

It didn’t help that VXX was released during the sky-high levels the VIX was printing in early 2009. Yet the costs of maintaining VIX exposure through front month contracts has proven extreme: VXX has lost 98% since January 2009.

12 20 12 2 300x170 Trade of the Day: iPath S&P 500 Dynamic VIX ETN (XVZ)
Click to Enlarge
While iPath says that VXX was designed as a short-term hedge, the two-year chart shows the long-term costs of this premium decay.

While the VIX is at almost the same levels from 2011, VXX has shed nearly 81%. The correlation between the two is strong but the price to keep VXX is very high – and in most circumstances will defeat the purpose of staying long volatility.

XVZ:A Better Trade-Off

One of VXX’s cousins, iPath S&P 500 Dynamic VIX ETN(NYSE:XVZ), lessens premium decay through both front month and mid-term VIX futures contracts. This helps XVZ during less volatile periods, but also opens up the risk of futures curve flattening. When the futures curve is flat or inverted, XVZ stays long in the short-term and mid-term contracts. When the curve becomes steep (i.e. the premiums in the short end of the curve are high) it offsets the costs of accelerated premium decay by shorting the front month contracts while staying long the mid-term contracts. But in order to keep its net long volatility exposure, it will always have a heavier long position at the back end of the curve than the short position at the front. This can cause XVZ to lose value even when volatility spikes. If the front month premiums rise more rapidly than the back end, XVZ may not gain as much from a VIX spike. It is a trade-off that counteracts premium decay during normal times but moderates big price increases.

12 20 12 3 300x170 Trade of the Day: iPath S&P 500 Dynamic VIX ETN (XVZ)
Click to Enlarge
XVZ held its value well for most of 2011-2012, following the VIX in a manner most investors could be comfortable with. However, since September, a flattening of the futures curve has caused it to decline. Yes, the VIX has been testing its long-term support between 14-16, but the curve flattening has been more responsible for XVZ’s 16% drop.

Now, though, the futures curve is back to average levels since 2008. So current levels may be a suitable entry point to hedge against volatility, especially with fiscal cliff issues still on the table. XVZ is a better value with futures curve flattening less likely going forward and with the VIX at complacent levels.

Chances are that fiscal cliff consequences may not be as severe as feared. But this is all the more reason to keep selective long volatility strategies in your portfolio. The real risks will likely come from a place few people are looking. Keeping a portion dedicated to a long volatility strategy such as XVZ may test your patience during periods of low volatility. But it will look prudent when the market gets shaken out of its slumber.

Recommendation: Go long XVZ to hedge potential unexpected selling towards the end of the year, but trigger the trade on the way back up. Enter the trade when XVZ crosses back above $47 per share. The holding period is likely to be short-term, with $50 and $56 per share as conservative and aggressive price targets.

Option Alternative: Because XVZ is a VIX-based ETN, it is basically an option already. However, for traders looking for a leveraged way to execute a similar trade, we would recommend entering the at-the-money long put option in the SPDR S&P 500 ETF Trust (NYSE:SPY) with an April 2013 expiration triggered by a cross above $47 per share.

John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.



Article printed from InvestorPlace Media, http://investorplace.com/247trader/trade-of-the-day-ipath-sp-500-dynamic-vix-etn-xvz/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.