This ETF Flaw Caused Subscribers a 30% Loss, But we Fought Back

I am about to share the worst trade of my carrier with you. It cost me a fair amount of sleep (and probably cost me a number of subscribers, who must have thought Simon is quite the moron).

Here is the sad tale of a good trade hijacked by an ETF flaw (fortunately there’s a happy ending).

The Setup

Earlier this year, in mid-January, we saw a number of VIX extremes, such as highly elevated SKEW readings (SKEW measures ‘black swan’ risk), near-record SKEW/VIX ratio readings and the highest ever long exposure of commercial VIX traders (smart money). The charts below, published by the Proift Radar Report in January, illustrate the extremes.

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Statistically, those conditions led to an average VIX spike of 22% over the next month every time (even a week later the VIX was higher 85% of the time).

The biggest problem (which we were well aware of) was the lack of a suitable trading vehicle for long VIX exposure. Yes, there is VXX, but it suffers from contango (we have often successfully shorted the VIX via XIV, which puts contango in our favor, more about XIV below).

What is Contango?

Below is a brief explanation of contango (taken from an August 2014 report):

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create ETPs like the iPath S&P 500 Short-Term VIX Futures ETN (VXX) are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

The chart below compares the current spot price with various futures prices. The difference between the spot price (12.20) and the September futures (13.45) is 9.84%. In other words, it will take a 9.84% move in the VIX to neutralize the time decay between the spot and September futures price.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango vs the Setup

Despite contango, the VIX buy signal seemed strong enough to deliver a net gain (a 20% short-term VIX spike tends to translate into a 5-7% VXX gain). We were looking for a short-term VIX spike, before a multi-week S&P 500 rally.

On January 23, we pulled the trigger and bought a very small amount of VXX at 20.60. A week later, the VIX traded higher, and a month later, the VIX traded higher. The VIX even spiked 22% (as expected) a number of times, but VXX contango persistently eroded VXX.

VXX by-passed the short-term VIX spike, and then, as anticipated, the stock market continued higher (which kept the VIX depressed). Nevertheless, we expected a period of choppy trading (volatility) to start in February/March.

On March 1, the S&P 500 topped, and has basically been range bound since.

On March 23, it was obvious that the VIX would fall again before the next window for a S&P 500 correction arrived. We bought XIV to hedge VXX, which turned out to be a great move.

The Next Window

The window to unwind this unfortunate VIX trade finally arrived this week. The May 14 Profit Radar Report stated that: “We are still looking to sell XIV and double up on VXX at S&P 2,407. Aggressive traders may elect to short the S&P around 2,410.”

Unfortunately there was another blow. The S&P 500 missed our trigger level for XIV and VXX (2,407) by one point (on Tuesday, March 16). The S&P gapped lower the next morning (by 17 points), robbing us of the best opportunity to unwind this trade.

We took the second-best opportunity. The March 17 intraday Profit Radar Report recommended to sell XIV at 77.40, and double up on VXX at 14.45. We closed XIV for a profit of 12.17% and bought VXX at 14.45.

The next morning (Thursday, March 18) we closed our entire VXX trade at 15.97. The VXX portion bought on January 23 accrued a 22.47% loss, the VXX portion bought on May 17 ended with a 10.51% gain. The 11.96% loss was offset by the 12.17% XIV gain.

At the end, we closed this unfortunate trade combo with a tiny 0.21% gain.

Lessons Learned

Patience and impeccable timing (at the end) rescued this trade, but in hindsight, the best worst trade is one not taken.

Contango needs to be respected. In the past, we traded XIV six times (XIV benefits from contango). All six XIV trades were profitable (12.17%, 14.46%, 13.33%, 7.57%, 15.70%, 4.49%). It’s better to focus on XIV (falling VIX) than VXX (rising VIX), especially in a bull market.

Although we knew that the VIX would fall mid-term, we bet on a short-term rise. It’s not smart to bet against the larger trend.

With the VXX trade closed at a miniscule profit, we keep our streak of no losing trade (since June 2015) alive.

The Profit Radar Report provides about 20 specific trade setups per year.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

 

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The Spectacular VIX Tailwind Trade

This is a reprint of the August 24 Special Profit Radar Report:

The CBOE Volatility Index (VIX) is a popular index, but in itself is not investable. You can’t just go out and buy the VIX. The same is true for the S&P 500 or any other index.

But investment vehicles like the SPDR S&P 500 ETF, which aims to replicate the performance of the S&P 500 index, make it possible to invest in indexes.

Duplicating the performance of the S&P 500, however, is much easier than creating a vehicle that mimics the VIX. Fund managers simply purchase the stocks that make up the S&P 500 to create an S&P 500-like product.

It doesn’t work like this for the VIX. Here’s why:

There is no ‘VIX stock.’ The only way to invest in the VIX is via futures or options, which are complex financial instruments. ETFs, ETNs or other ETP’s use futures or options to attain ‘VIX-like’ performance. VIX futures and options generally suffer from some sort of time decay.

Explained: Contango

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create ETPs like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

Figure 1 compares the current spot price with various futures prices. The difference between the spot price (12.20) and the September futures (13.45) is 9.84%. In other words, it will take a 9.84% move in the VIX to neutralize the time decay between the spot and September futures price.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango generally exists when the VIX is flat or trending lower. Even gradual increases when the VIX is below 20 tend to occur in an environment of contango.

Backwardation (figure 2) is the opposite of contango. Backwardation generally appears only during times of panic and significant VIX spikes above 20.

To sum up, contango erodes investors’ returns during periods of a flat or falling VIX.

How to Profit from Contango

We don’t expect a major stock market top yet, therefore the period of low volatility is likely to continue (or resume after the seasonal October VIX high).

Is it possible to use contango in our favor?

Figure 3 plots the VIX against the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), and reveals a very simple truth: XIV has risen much more than the VIX has fallen.

Figure 4 shows the cumulative gain/loss from January 3, 2011 to August 15, 2014. The VIX lost 25%. XIV gained 242%. XIV returned 217% more than the inverse VIX.

XIV’s objective (and the objective of every other inverse or leveraged ETP) is to replicate the daily (not long-term) inverse performance of the VIX, but regardless, this kind of excess return is worth exploring.

Here is a more detailed breakdown of XIV’s excess return.

XIV is an inverse VIX ETN. For an apples to apples comparison, we are comparing XIV with a simple inverse VIX.

Of the 911 trading days from January 3, 2011 to August 15, 2014, the inverse VIX had 484 up days and 427 down days. The inverse VIX had 1.13x more up than down days.

The average gain of 484 up days was 4.55%. The average loss of 427 down days was 5.85%. The average loss was 1.28x greater than the average gain.

Of the 911 trading days from January 3, 2011 to August 15, 2014, XIV had 522 up days and 389 down days. XIV had 1.34x more up than down days.

The average gain of 522 up days was 2.63%. The average loss of 389 down days was 3.18%. The average loss was 1.21x greater than the average gain (see figures 5 and 6).

Summary

Since 2011, XIV outperformed the inverse VIX by 217% (0.24% per day). Although there are other factors at work, the excess return of 0.24% per day is largely attributed to the effect of contango.

Contango does not guarantee a profitable trade or protect against losses. From July 7 – November 21, 2011 XIV lost 75%. There are also times where the VIX moves lower and XIV loses value (i.e. August 18 – 21, 2014).

Over time however, contango significantly enhances the odds of a successful XIV trade, especially when XIV is purchased during times of VIX spikes.

A list of VIX Exchange Traded Products that benefit from contango, a updated VIX seasonality chart, and actual buy/sell signals are available via the Profit Radar Report.

Simon Maierhofer is the founder of iSPYETF and the publisher of the Profit Radar Report. Barron’s rated iSPYETF as a “trader with a good track record” (click here for Barron’s profile of the Profit Radar Report). The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013, 17.59% in 2014, and 24.52% in 2015.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

3 Tricks for Trading the VIX

More than any other asset class, the Volatility Index (VIX) is subject to distinct patterns or biases that either help or hurt investors.

Being aware of the 3 VIX tricks discussed below will significantly increase the odds of a winning trade.

1) VIX Seasonality

I invite you to inspect the VIX seasonality chart below. Based on 25 years of trading history, there are two important seasonal turning points: July 2 and October 9.

The VIX has a strong tendency to move higher starting in early July (green arrow), and to move lower after early October (red arrow).

For example, the June 23, 2015 Profit Radar Report stated that: “The VIX closed below the lower Bollinger Band for the first time since June 6, 2014. A close back above the lower Bollinger Band will be a buy signal. VIX seasonality is soon turning higher for the best VIX seasonal signal of the year.”

Shortly thereafter the VIX rallied from 12 to 20 and eventually to 50.

Due to the massive summer spike, this year’s October sell signal was shifted.

Nevertheless, the November spike (last chart, red arrow) offered a good setup to short the VIX, as the November 16 Profit Radar Report brought out: “The VIX closed below the upper Bollinger Band, which is a sell signal.”

The October sell signal is particularly intriguing because it gets magnified by a major bias of inverse VIX ETPs (Exchange Traded Products, such as ETFs and ETNs). This bias can be worth 0.25% per day for weeks.

2) Inverse VIX Bias

ETPs like the iPath S&P 500 VIX ETN (VXX) or the VelocityShares Daily Inverse VIX ETN (XIV) use futures (or options) to replicate VIX-related performance.

The performance of futures-based ETPs is typically cannibalized by a condition called contango. However, a bet on lower VIX prices allows investors to turn this generally harmful condition into a superbly beneficial tail wind.

Below is an admittedly dry explanation of contango, but I think you will find it well worth your time (no pain, no gain).

The VIX quoted in-day-to-day life is the CBOE Volatility Index (VIX) spot price (today’s VIX price). However, the futures used to create VIX ETPs are based on the future VIX price, which is almost always more expensive than the spot price. Over time the more expensive VIX futures decline in value, eventually converging with the spot price at expiration.

As time goes by, ETF providers are forced to continuously replace expiring futures with new (more expensive) futures (this process is called ‘rolling over’). The further away the futures expiration date, the bigger the time premium. This time premium and resulting value decay is called contango.

Contango generally exists when the VIX is trading below 20. The opposite of contango – backwardation, when future VIX prices are lower than at present – generally appears when the VIX trades above 20.

I wrote a detailed report on how to actually make contango work for investors back on August 24, 2014 (entire report available to subscribers of the Profit Radar Report).

Below are some of the findings and charts shared in this report:

The two biggest beneficiaries of the ‘reverse contango’ benefit are the VelocityShares Daily Short-term VIX ETN (NYSEArca: XIV) and ProShares Short VIX Futures ETF (NYSEArca: SVXY).

The chart below compares the VIX with its inverse counter part, XIV. Shown is the cumulative percentage return from January 3, 2011 to August 15, 2014.

It quickly becomes obvious that XIV has risen much more than the VIX has fallen.

XIV is an inverse VIX ETN. For an apples to apples analysis of the excess return, here is a comparison between XIV and an inverse VIX (the VIX inversed).

  • Of the 911 trading days from January 3, 2011 to August 15, 2014, the inverse VIX had 484 up days and 427 down days. The inverse VIX had 1.13x more up than down days.
  • The average gain of 484 up days was 4.55%. The average loss of 427 down days was 5.85%. The average loss was 1.28x greater than the average gain.
  • Of the 911 trading days from January 3, 2011 to August 15, 2014, XIV had 522 up days and 389 down days. XIV had 1.34x more up than down days.
  • The average gain of 522 up days was 2.63%. The average loss of 389 down days was 3.18%. The average loss was 1.21x greater than the average gain (see figures 5 and 6).
  • From January 3, 2011 to August 15, 2014, XIV outperformed the inverse VIX by 217% (0.24% per day).

Obviously the reverse contango benefit doesn’t guarantee a profitable trade, but on average XIV provides a ‘daily edge’ of 0.25%. At times, the edge is much more pronounced, such as on November 30, 2015, when the VIX rose 6.68%, but XIV gained 0.74% (when it should have lost some 6.68%).

VIX Technical Analysis

As you may have noticed from the two above Profit Radar Report quotes, the Bollinger Bands can be very helpful when it comes to spotting buy/sell signals, especially when they occur near the two major seasonal turning points (see chart below).

Simple support/resistance levels and trend channels can also be of help. The green/red arrows below highlight the buy/sell signal given by the Profit Radar Report.

Summary

Seasonality and technical analysis triggered a VIX sell signal on November 16.

The sell signal remains active and the ‘contango tailwind’ should by overall positive for XIV until late December.

However, for the first time since the start of the 2009 bull market, we are seeing signs of distribution (liquidity is drying up). This could become an issue when the next (bullish) VIX turning point arrives.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Strongest Seasonal VIX Buy Signal of the Year is Here

The June 23 Profit Radar Report featured the following VIX analysis:

“The VIX closed below the lower Bollinger Band for the first time since June 6, 2014. It is at the general support zone at 12. The next support zone is at 11. A close back above the lower Bollinger Band will be a buy signal.

VIX seasonality is soon turning higher for the best VIX seasonal signal of the year. Profiting from a rising VIX is always made tougher by contango, which persistently erodes returns of VIX related ETFs like VXX. Nevertheless, the best VIX buy signal of the year appears imminent. We would certainly be buyers at 11. For now, we’ll place a buy limit order (small initial amount) for VXX at 16.90.”

The significance of the close below the lower Bollinger Band was enhanced by VIX seasonality.

Seasonality is not an exact science, but 24 years of VIX history have carved out certain patterns that repeat more often than not.

One of those patterns is an early July VIX bottom.

The chart below plots the VIX against VIX seasonality. Click here for VIX seasonality chart.

Thanks to Greece, the VIX bottom may have arrived a few days earlier, making it tougher for latecomers to buy at the bottom.

Nevertheless, the VIX seasonality chart suggests we may see another opportunity to buy VIX related ETNs like the iPath S&P 500 Volatility ETN (NYSEArca: VXX) or VelocityShares Daily 2x Short-term Volatility ETN (NYSEArca: TVIX) next week.

 

I Spy … A Rare VIX Signal for the S&P 500

The 30-day VIX (VIX) is trading 23% lower than the 90-day VIX (VXV). This means VIX traders are less concerned about shorter-term (30-day) volatility than longer-term (90-day) volatility.

You may be thinking short-term complacency is a contrarian indicator … and you are right.

To provide a visual of short-term complacency, I’ve calculated the ratio between VIX and VXV and plotted it against the S&P 500.

For only the second time since April 2013, the VIX:VXV ratio dropped below 0.78 (view a long-term version of the VIX:VXV ratio chart here)

Prior sub 0.79 readings are highlighted with a dashed red line.

 

The conclusion is more or less self-explanatory.

This indicator has a pretty good track record and increases the odds of a S&P 500 (NYSEArca: SPY) pullback and VIX rise. Long VIX ETFs include the iPath S&P 500 Short-term VIX Futures ETN (NYSEArca: VXX) and VelocityShares Daily 2X ST VIX ETN (NYSEArca: TVIX).

Two things to keep in mind:

  • This is likely to be a short-term (3 – 10 days) trade.
  • In terms of risk management; a VIX close below support at 12.70 would temporarily (as long as it stays below 12.70) suspend the potential for a spike.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013 and 17.59% in 2014.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

VIX Option Traders Ratio Signals S&P 500 Bounce

We’ve looked at the VIX/VXV ratio several times in the past. This has been a very helpful and generally accurate indicator.

Here’s how it works:

The VIX (NYSEArca: VXX) reflects how volatile traders expect the next month to be. The VXV reflects how volatile traders expect the next three months to be.

The expectation of increased short-term volatility relative to long-term volatility (VIX/VXV ratio above 1) is usually a contrarian indicator, which means short-term volatility is about to level off and the S&P 500 (NYSEArca: SPY) is about to move higher.

The VIX/VXV ratio popped to 1.03 yesterday. This is the highest reading since October 17.

The green lines show that readings above 1 marked a low 3 out of 4 times.

Right now, this bullish VIX/VXV ratio reading does not jibe with my overall outlook, but it has to be respected to some degree.

Here’s my short-term S&P 500 forecast, which considers the ramification of the VIX/VXV ratio in combination with other indicators.

Short-term S&P 500 Forecast

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

New Year’s VIX Hangover Explained

Here is one of the biggest trading anomalies on Wall Street: Since 1970, the S&P 500 delivered a year-end rally 76.1% of the time, but the VIX declined over the same period only 13.8% of the time.

Since 1970, the S&P 500 staged a year-end rally (often considered the Santa Claus Rally, comprised of the last five trading days of the old year, and first two trading days of the new year) 35 out of 46 years, or 76.1% of the time.

The average gain is around 1.5%. This rally has been reliable enough that investors view it as a foregone conclusion.

Despite the strong propensity for the S&P 500 (NYSEArca: SPY) to rally, the VIX has declined only 4 of the last 29 years.

This is one of those charming and somewhat inexplicable VIX anomalies.

We don’t need to understand every anomaly as long as we are aware of it.

The December 23 Profit Radar Report highlighted this quirk by comparing VIX and S&P 500 seasonality (see chart below) and stated:

Year-end S&P 500 seasonality is quite strong, as is VIX seasonality. This is one of those ‘charming’ VIX quirks that doesn’t make sense. Therefore, we are closing our VelocityShares Daily Inverse VIX ETN (NYSEArca: XIV) position at 34.90.”

If the VIX rises when stocks are up, imagine what happens when stocks are down. We don’t have to imagine, we just saw it.

Inverse volatility ETFs like XIV and SVXY has dropped like a rock wile the iPath S&P 500 VIX ETN (NYSEArca: VXX) soared like an eagle. Based on historical data, this would have happened anyway, even without S&P 500 selloff.

VIX seasonality is somewhat choppy until early March, so trading the VIX will take good timing.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.