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What is XIV and how does it work?  XML
Forum Index » What is XIV and how it works?
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Joined: 06/01/2017 22:27:59
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XIV (VelocityShares Daily Inverse VIX Short-Term ETN) began trading in late 2010. Its short history has clearly demonstrated that it’s a product of extreme risks and extreme rewards. The maximum draw-down happened in late Nov 2011, just a year after it began trading, which resulted in a painful loss of more than 70% from the previous high just a short 5 months before. Its potential is equally great; from Nov 2011 to June 2014, it had a massive gain of more than 800%!

Trading/investing with XIV requires great tolerance of risk. It would be a great accomplishment if a signal can be developed to participate in most of its massive uptrends while avoid most of the heartbreaking drops.

Before investing in XIV, one must understand what XIV is, what it’s made of. To understand XIV, one must start with what volatility is.
1) What is volatility?
Volatility in finance is the magnitude of variation of return over a period of time. In statistics it’s called Standard Deviation. If volatility of a financial product is high, we say the risk is high.
There are two types of volatility: historical volatility (aka realized volatility), and implied volatility.
Historical Volatility: historical volatility is calculated based on the actual price movement of the past time period. For example, when we say that the S&P 500 index has a total return of 12%, and a standard deviation of 13% in 2016, we are talking about historical volatility of 13% during year 2016.
Historical volatility does not change much from one day to the next because when a new day’s data is added, the oldest data point is dropped, with the data from the rest of more than 250 trading days unchanged, the resulting change in historical volatility (for the past year) should not change dramatically from one day to the next. However such is not the case with implied volatility.

2) What is implied volatility?
Volatility is an important factor in determining option prices via Black-Scholes Formula. More volatile a stock is, more valuable the stock options are (both calls and puts). When a financial crisis hit or wars break out, market’s perception of future volatility shoots up, stock option becomes more valuable, and this jump in volatility is the jump in implied volatility. The implied volatility can change greatly from one day to the next. This implied volatility based on option prices (of the S&P 500 ) traded at a given moment is the spot volatility VIX (aka fear index). A graph of VIX clearly demonstrates that it can change drastically from one day to another. During the past 10 years it went as low as under 11, as high as 60.
Since volatility is a measure of risk, it’s not a physical entity as a stock certificate, or a barrel of oil, one cannot trade it directly. It can only be traded in the CBOE Futures Exchange (VIX futures), and unlike oil futures/grains futures, one cannot take delivery of VIX, one must settle at the settlement day.

3) What is VXX?
VXX (Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN) is an ETN, the value of which is determined by a hypothetical portfolio of the two nearest VIX futures contracts. To put simply, it buys the 2nd month’s VIX futures and sells the front month’s futures.

4) What is XIV?
XIV (VelocityShares Daily Inverse VIX Short-Term ETN) is essentially the opposite of VXX. It’s an ETN, the value of which is determined by a hypothetical portfolio of the two nearest VIX futures contracts. To put simply, it shorts the 2nd month’s VIX futures and cover the front month’s futures.

5) Why trade XIV and not VXX?
Due to the human psychology, the VIX futures with a farther expiration date is higher than VIX futures with a closer expiration date, more often than not. This condition is called “contango”. In a minority of times, the opposite is true, especially during financial crisis, or other global turmoil (called “backwardation”).
When “contango” exists, buying VXX amounts to buying high and selling low. Therefore it’s headed toward 0 over the long term, although it could sky rocket occasionally (during “backwardation”). Buying XIV is a much better proposition since the “contango” condition will propel it higher and higher over the long run, though “backwardation” condition will bring great crashes occasionally - such as the 70% loss in 2011, and it’s not inconceivable that worse loss may happen in the future.

6) How does XIV move with the S&P 500 index?
Although statistically speaking, Average going up doesn’t indicate Standard Deviation will go down or up. However practically, when S&P 500 index goes up, volatility usually goes down, and XIV usually goes up (since it’s an inverse volatility ETN). Similarly when S&P 500 index goes down, XIV tends to go down. This correlation exists probably due to the fact that when S&P 500 index goes down, investors are willing to pay more for put options to protect the holdings, causing implied volatility to go up.

7) what is the principle of our Model?
We recognize the great potential of XIV, but apprehensive about its down side risks. We developed the model with the goal to invest in VIX when it is safe (i.e., “contango” is established), and get out of XIV before it becomes dangerous (“backwardation”).




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Joined: 06/01/2017 22:27:59
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Anonymous wrote:Great post, lots of helpful information.

A question for your item 6: so basically in theory there is support for the correlation between S&P and XIV, your reasoning for that is simply a guess, but not proven. Am I right? Assuming your guess is not right, does that mean the XIV might go up in the future while S&P goes down? or the opposite? in that case, there is no way to play XIV.



As for the correlation between XIV and S&P 500 index, it can be shown with past data that there is a high correlation. In fact a writer on Seeking Alpha did just that and shows that the correlation is 0.8 in 2014 (note that the article was written in 2014 when history of XIV was relatively short, so the author created a synthetic XIV based on the inverse of VXX, which has a longer trading history. Using data going back to 2009, the author calculated the correlation as 0.. See the article here http://seekingalpha.com/article/1932831-are-the-vx...ding-leveraged-market-exposure

Now XIV has a few years of trading, one can calculate the correlation. I haven't done so myself, but correlation of 0.8 sounds about right to me. With a correlation 0.8, XIV usually moves in the same direction as S&P 500 index, but not always. But the magnitude of change in XIV is much greater than that of S&P 500 index.
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Joined: 06/01/2017 22:27:59
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Is shorting VXX better than buying XIV?

The short answer is yes. We will talk about two scenarios as below:

Scenario 1): Rebalance every day.
On day one, short $100 VXX vs Buy $100 XIV. If VXX is down 5%, and XIV is up 5%. Then you will rebalance to Short $105 VXX, vs no action for XIV (since XIV is now worth 105).
In this scenario, short VXX should be identical to buy XIV in theory. However since the expense is about 1% for each, and the end of the year short VXX should be 2% better than buy XIV. I remember I once to actually calculated it. The final results is much more than 2%.

Of course Scenario 1) is not practical. It's simple not possible to rebalance every single day.

Scenario 2): Rebalance only occasionally.
It's hard to say:

If either VXX or XIV is range bound, then short VXX is much better than buy XIV.

If XIV steadily increase, then buy XIV is better (of course you can do better with short VXX if you rebalance daily and commission is 0).

If XIV steadily decrease, buy XIV makes you sleep better. However if you have a mind of steel, short VXX is financially better eventually.

Conclusion: Short VXX is even more risky, but it is likely outperform long XIV.
 
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