I received the following question on StockTwits yesterday: “For investment-type equity trades (holding 6-12 months) would it not be better to hedge a stock portfolio with $VXZ?”
My answer is no, it’s not, for the simple reason that the iPath S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ) just doesn’t track the VIX closely enough.
It’s easy to see why VXZ sounds like it’s a good hedge for longer time horizons, after all, it proxies VIX futures out four to seven months. But here’s the problem. It’s constant duration, so it’s ALWAYS four to seven months away. And VIX futures that far away just don’t follow the VIX itself all that closely, as they perpetually anticipate some sort of mean reversion.
In my book, Options Volatility Trading: Strategies for Profiting From Market Swings, I use a weather analogy. Let’s say you want a contract on a weather forecast that looks forward from a date that’s a half year from now. If it’s unseasonably warm today, it’s not going to have much (if any) effect on such a contract. Same thing for the VIX. A pop in volatility today does not necessarily mean you should expect a trader looking 30 days forward from next February to price such options all that much higher.
This is why you see a graph like the one below that compares VXZ to VIX. I went back four months so as to include the May VIX pop. At the initial peak, the VIX had lifted about 180% versus 50% for VXX.
As the VIX lift persisted, VXZ caught up a bit in relative performance, mainly because, over time, “mean” expectations for the VIX lifted. In fact, those mean expectations remain high now as evidenced by the out-month futures premiums we often note.
In fact, it’s those elevated futures that lead me to think now is a particularly bad time to use VXZ as a longer-term volatility hedge. The futures markets are already pricing in a fall VIX pop.
VXZ doesn’t have the contango drag of the iPath S&P 500 VIX Short Term Futures ETN (NYSE: VXX), as the futures premiums don’t have perceptible erosion that far out, and there’s a flat spread between them. But if you want to hedge a move out in time, I think you’re better off just using VXX. Despite its shortcomings, it will better track the pops than VXZ, which is, after all, what you’re hoping to accomplish with this kind of hedge.
Follow Adam Warner on Twitter @agwarner.
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