The XIV Meltdown
By: Tony Yiu
Tags: Economics, Trading, Finance, Money, Investing

What is the VIX? And Why Does Everyone Short It?

Check out the chart below. The dark blue line is SVXY, an ETF that shorts VIX futures (that is still alive and kicking today unlike XIV). The light blue line (that pretty much looks horizontal) is the S&P 500.

From the start of 2013 to the end of 2017, the S&P 500 earned a handsome 86% return, nearly doubling your money. Over the same timeframe, shorting the VIX via SVXY earned an incredible 565% return, nearly septupling (from 1 to 7) your money! These ridiculous returns over relatively short timeframes are why people keep visiting the VIX casino.

Source: Yahoo Finance

So what is this VIX that I keep talking about? The technical definition of the VIX is the implied volatility of S&P 500 options. But how it is calculated is way less important than what it represents.

Simply put, the VIX measures stock market fear and investor uncertainty.

When things are going well, the VIX tends to trend lower and lower. When markets crash, the VIX spikes.

Being long the VIX is equivalent to buying insurance against a market crash, while shorting the VIX is equivalent to selling crash insurance.

So How Does an Index of Market Fear Become Such a Goldmine?

Two factors drive returns for those shorting the VIX:

Markets tend to trend up over time — as markets go up, the VIX gradually declines (and if the VIX goes down, VIX shorts profit). The VIX futures curve generally has a positive slope — meaning that if you are long the VIX, you are constantly buying high and selling low (more on this below).

Point 2 is pretty important. Let’s take a deeper look at the VIX futures curve. First what is a futures curve? A futures contract is a promise to buy an asset at a predetermined price at some point in the future.

The plot below shows a hypothetical VIX curve. Each blue dot is a futures contract with a specified expiration date — for example, the first blue dot is the VIX futures contract expiring in exactly one month from today. Now because the VIX is not directly investible at the market price (in finance this is called the spot price), managers of a VIX focused ETF like XIV are forced to use futures contracts to get their exposure.

Being Long the VIX Futures Curve — Buy High Sell Low

So like I depict in the chart above, managers will buy the VIX futures contract expiring in two months (the green “Buy Here”) and hold that to get long exposure to the VIX. But after a month goes by, that futures contract that started as a two month contract is now a one month contract (the red “Sell Here”). And in order to maintain constant exposure to the VIX, the manager sells the contract he owns, now a one month contract, and buys a new two month contract (this transaction is depicted by the dashed line labeled “Repeat”).

Now recall that the VIX curve is generally upward sloping. This means that every month the manager is selling low at the red in order to buy high at the green, a process called “rolling down the VIX curve”. Some numbers might make this easier to visualize:

We purchase the VIX futures contract two months out for $100. After one month passes and assuming the VIX futures curve doesn’t materially change shape, our previously purchased contract is now a one month contract worth only $97. Now it’s time to reset our exposure — so we sell our one month contract for $97 and buy a new two month contract for $100 losing $3 (-3% return) in the process. And since we need to do this every month, we get hit with a 3% loss every month as long as the VIX curve remains upwards sloping.

So being long the VIX in a rising or stable stock market is equivalent to bleeding money month after month. So why not turn this around, short VIX futures instead, and earn all that money that investors long the VIX are bleeding? And that’s what plenty of people did.

By simply flipping the direction of the trade, investors put themselves in a position to sell high (red “Short Here”) and buy back low (“Buy Back Here”) month after month: