VIX HEDGES

Institute of Trading & Portfolio Management

What is the VIX

The VIX is an implied volatility index on the S&P500. Its calculation is designed to produce a constant measure of 30-
day expected volatility (presented as an annualized figure) of the US stock market derived from real-time mid-prices
of S&P 500 options.

If you would like to look at the construction of the index in more detail you can find the CBOE white paper on
the subject here: https://cdn.cboe.com/resources/vix/vixwhite.pdf

VIX Levels

VIX % Volatility VIX % Volatility

Value Yearly Monthly Weekly Daily Value Yearly Monthly Weekly Daily
1 1.00% 0.29% 0.14% 0.06% 51 51.00% 14.72% 7.07% 3.21%
2 2.00% 0.58% 0.28% 0.13% 52 52.00% 15.01% 7.21% 3.28%
3 3.00% 0.87% 0.42% 0.19% 53 53.00% 15.30% 7.35% 3.34%
4 4.00% 1.15% 0.55% 0.25% 54 54.00% 15.59% 7.49% 3.40%
5 5.00% 1.44% 0.69% 0.31% 55 55.00% 15.88% 7.63% 3.46%
6 6.00% 1.73% 0.83% 0.38% 56 56.00% 16.17% 7.77% 3.53%
7 7.00% 2.02% 0.97% 0.44% 57 57.00% 16.45% 7.90% 3.59%
8 8.00% 2.31% 1.11% 0.50% 58 58.00% 16.74% 8.04% 3.65%
9 9.00% 2.60% 1.25% 0.57% 59 59.00% 17.03% 8.18% 3.72%
10 10.00% 2.89% 1.39% 0.63% 60 60.00% 17.32% 8.32% 3.78%
11 11.00% 3.18% 1.53% 0.69% 61 61.00% 17.61% 8.46% 3.84%
12 12.00% 3.46% 1.66% 0.76% 62 62.00% 17.90% 8.60% 3.91%
13 13.00% 3.75% 1.80% 0.82% 63 63.00% 18.19% 8.74% 3.97%
14 14.00% 4.04% 1.94% 0.88% 64 64.00% 18.48% 8.88% 4.03%
15 15.00% 4.33% 2.08% 0.94% 65 65.00% 18.76% 9.01% 4.09%
16 16.00% 4.62% 2.22% 1.01% 66 66.00% 19.05% 9.15% 4.16%
17 17.00% 4.91% 2.36% 1.07% 67 67.00% 19.34% 9.29% 4.22%
18 18.00% 5.20% 2.50% 1.13% 68 68.00% 19.63% 9.43% 4.28%
19 19.00% 5.48% 2.63% 1.20% 69 69.00% 19.92% 9.57% 4.35%
20 20.00% 5.77% 2.77% 1.26% 70 70.00% 20.21% 9.71% 4.41%
21 21.00% 6.06% 2.91% 1.32% 71 71.00% 20.50% 9.85% 4.47%
22 22.00% 6.35% 3.05% 1.39% 72 72.00% 20.78% 9.98% 4.54%
23 23.00% 6.64% 3.19% 1.45% 73 73.00% 21.07% 10.12% 4.60%
24 24.00% 6.93% 3.33% 1.51% 74 74.00% 21.36% 10.26% 4.66%
25 25.00% 7.22% 3.47% 1.57% 75 75.00% 21.65% 10.40% 4.72%
26 26.00% 7.51% 3.61% 1.64% 76 76.00% 21.94% 10.54% 4.79%
27 27.00% 7.79% 3.74% 1.70% 77 77.00% 22.23% 10.68% 4.85%
28 28.00% 8.08% 3.88% 1.76% 78 78.00% 22.52% 10.82% 4.91%
29 29.00% 8.37% 4.02% 1.83% 79 79.00% 22.81% 10.96% 4.98%
30 30.00% 8.66% 4.16% 1.89% 80 80.00% 23.09% 11.09% 5.04%
31 31.00% 8.95% 4.30% 1.95% 81 81.00% 23.38% 11.23% 5.10%
32 32.00% 9.24% 4.44% 2.02% 82 82.00% 23.67% 11.37% 5.17%
33 33.00% 9.53% 4.58% 2.08% 83 83.00% 23.96% 11.51% 5.23%
34 34.00% 9.81% 4.71% 2.14% 84 84.00% 24.25% 11.65% 5.29%
35 35.00% 10.10% 4.85% 2.20% 85 85.00% 24.54% 11.79% 5.35%
36 36.00% 10.39% 4.99% 2.27% 86 86.00% 24.83% 11.93% 5.42%
37 37.00% 10.68% 5.13% 2.33% 87 87.00% 25.11% 12.06% 5.48%
38 38.00% 10.97% 5.27% 2.39% 88 88.00% 25.40% 12.20% 5.54%
39 39.00% 11.26% 5.41% 2.46% 89 89.00% 25.69% 12.34% 5.61%
40 40.00% 11.55% 5.55% 2.52% 90 90.00% 25.98% 12.48% 5.67%
41 41.00% 11.84% 5.69% 2.58% 91 91.00% 26.27% 12.62% 5.73%
42 42.00% 12.12% 5.82% 2.65% 92 92.00% 26.56% 12.76% 5.80%
43 43.00% 12.41% 5.96% 2.71% 93 93.00% 26.85% 12.90% 5.86%
44 44.00% 12.70% 6.10% 2.77% 94 94.00% 27.14% 13.04% 5.92%
45 45.00% 12.99% 6.24% 2.83% 95 95.00% 27.42% 13.17% 5.98%
46 46.00% 13.28% 6.38% 2.90% 96 96.00% 27.71% 13.31% 6.05%
47 47.00% 13.57% 6.52% 2.96% 97 97.00% 28.00% 13.45% 6.11%
48 48.00% 13.86% 6.66% 3.02% 98 98.00% 28.29% 13.59% 6.17%
49 49.00% 14.15% 6.80% 3.09% 99 99.00% 28.58% 13.73% 6.24%
50 50.00% 14.43% 6.93% 3.15% 100 100.00% 28.87% 13.87% 6.30%
VIX vs Stock Market (S&P500) Correlation

Historically speaking, the VIX and the Stock Market, or S&P500, have had a negative correlation. You can see below,
in times of market stress and illiquidity, the S&P500 tends to decrease whilst the VIX increases.

Equally, the S&P500 has near bottoms when the VIX spikes, and the VIX often trends down as the S&P500 trends up.
This negative correlation is formalised in the chart below:

Demand for VIX Related Products

After the 2008 financial crisis there was a lot of demand for VIX related products due to its performance potential in
market downturns. Much of the demand came from those managing accounts that could be long-only (for example
pension fund managers and retail traders/investors), who wanted to be able to trade volatility products so they
could hedge their underlying portfolios. There were volatility products already around, in the form of VIX futures and
options, but due to various restrictions many money managers and retail clients were not (and still aren’t) able to
trade them directly.

So, Barclays (along with other custodians) took advantage of the situation and created ETFs and ETNs such as the
VXX. The idea was that these products would give retail (and professional) investors and traders the opportunity to
get exposure to the VIX and hence provide protection in market downturns and deliver the hedge they desired. The
prices of these ETFs and ETNs are themselves derived from underlying VIX futures and options.
How to Trade the VIX

When it comes to Retail Traders and Investors, as highlighted already the reality is that you cannot trade the VIX
directly, and for most, VIX futures and options are inaccessible as well. So in order to get exposure to the value of
the VIX you must instead take positions volatility ETFs and ETNs such as those created in the aftermath of the 2008
crisis.

These products are easily tradable for retail traders, but none of them track the VIX particularly closely over longer
periods, and in fact they are susceptible to market manipulation and can actually be “broken”. For example, on
February 5th 2018 the VIX was up 104% from its previous close which broke the XIV (inverse VIX ETF) which caused
the fund to liquidate.

The VXX

Let’s look at a typical example of a volatility ETN, the VXX, and consider it in the context of trading it with the
intention to hedge a long-only portfolio. To start, below is a description of the VXX provided on the Barclays iPath
website:

The iPath® Series B S&P 500® VIX Short-Term FuturesTM ETNs (the "ETNs") are designed to provide exposure
to the S&P 500® VIX Short-Term FuturesTM Index Total Return (the "Index"). The ETNs are riskier than
ordinary unsecured debt securities and have no principal protection. The ETNs are unsecured debt
obligations of the issuer, Barclays Bank PLC, and are not, either directly or indirectly, an obligation of or
guaranteed by any third party. Any payment to be made on the ETNs, including any payment at maturity or
upon redemption, depends on the ability of Barclays Bank PLC to satisfy its obligations as they come due. An
investment in the ETNs involves significant risks, including possible loss of principal and may not be suitable
for all investors.

The Index is designed to provide access to equity market volatility through CBOE Volatility Index® (the "VIX
Index") futures. The Index offers exposure to a daily rolling long position in the first and second month VIX
futures contracts and reflects market participants’ views of the future direction of the VIX index at the time of
expiration of the VIX futures contracts comprising the Index. Owning the ETNs is not the same as owning
interests in the index components included in the Index or a security directly linked to the performance of the
Index.

Apart from the issuer absolving itself for any losses or the product not delivering on its intention, there is something
else this description hints at that is very important regarding the structure of the VXX. The values of the VXX is based
on rolling VIX futures contracts, not the VIX itself. As discussed previously this is typical of almost all volatility ETFs
and ETNs.

Let’s take a step back for a moment and just eyeball the chart performance of the VXX and VIX instruments:
It’s pretty clear to see that something isn’t right here. Traders and Investors want exposure to the VIX index, and so
buy the VXX, but yet historically, we can observe that the performance of the VXX is nothing like the VIX. This stems
from the fact that the VXX (and other volatility ETFs) are structured by using rolling futures VIX contracts to dictate
the value of the fund.

The reason why that is a problem, is because the majority of the time VIX futures often don’t trade at the same
prices as the spot price. Typically, they have what is called a “contango” term structure. This is when futures prices
trade higher than the current spot price – which can be for various reasons that we won’t go into here. As a
reference though, below is an example of what a contango term structure looks like for VIX futures:
For those that don’t know a futures contract is a legal agreement to buy or sell a particular commodity asset, or
security at a predetermined price at a specified time in the future. The buyer of a futures contract is taking on the
obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures
contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

At the expiration date of a futures contract, the price of the future must (by definition) match the current spot price.
And so, when futures trade in a contango term structure, the futures are structurally predisposed to decline as they
converge to the spot price. This is the reason why the VXX and other volatility ETFs/ETNs are structurally destined
to decline – they almost always have negative rollover yield.

That being said, there are times when contango doesn’t exist in VIX futures. Backwardation is when the current spot
price trades higher than the futures price and this is usually due to short-term demand shocks, typically this occurs
when there is a short-term volatility spike and the market gets spooked. For example, this happened on 7th May
2019 when the China-US trade deal was put into jeopardy:
VXX Performance

Below are some charts and tables illustrating the performance of the VXX over time. As explained previously, the
structural decline in price is due to the VXX being derived from VIX futures which are almost always priced with a
Contango term structure.

05-Oct-21
Returns VXX S&P500
YTD -62.23% 16.21%
1-Month 10.55% -5.18%
3-Month -6.32% -1.58%
6-Month -34.29% 5.40%
1-Year -72.78% 27.95%
2-Year -72.82% 47.31%
3-Year -79.89% 56.34%
All Time -99.99% 24114.30%

VXX SP500
2021- -62.23% 16.21%
2020 15.71% 15.29%
2019 -66.77% 28.71%
2018 73.95% -7.01%
2017 -70.55% 18.42%
2016 -70.11% 11.24%
2015 -35.14% -0.69%
2014 -27.46% 12.39%
2013 -62.08% 26.39%
2012 -76.38% 11.68%
It’s pretty clear that the performance has been dreadful, both on an absolute basis and relative to the S&P500. The
original pitch by Barclays and other providers was that you should put a percentage of your portfolio, for example
25%, into the VXX as a hedge to the market. It’s pretty obvious from the returns above that if you implemented a
buy and hold strategy as a hedge to your long portfolio your portfolio would have been destroyed, as many retail
traders have found out.

Eventually though, retail traders and investors gradually realized they were getting screwed on this trade and by
2018 many were starting to do the opposite – going short the VXX due to their own recency bias when looking at
past performance. They saw the structural decline of the VXX and other related instruments and wanted to reverse
their losses from their original “hedging” positions.

Again, this proved to be an ill-informed idea. On March 26th 2018 the VXX had a year-to-date return of 58.85% -
more than enough to wipe out thousands of short-selling retail traders. Those that thought they might hedge their
short VXX positions with long SPY positions quickly realized this was also a mistake, since the S&P500 actually
returned around 2% over the same period. This trade absolutely destroyed many accounts, both retail and
professional, and illustrates why you can’t just “short and hold” volatility ETFs/ETNs either.

Conclusion

When it comes to hedging, although the Stock Market and the VIX are inversely correlated over longer periods, they
are not always inversely correlated over shorter periods. To add to that, instruments like the VXX don’t track the VIX
accurately over time due to negative rollover yield. The result is that unless you know what you are doing, trading
these volatility instruments isn’t worth it – you can get burned very easily both on the way up and the way down.

Being long volatility products like the VXX as a “buy and hold” hedge to long-only portfolios doesn’t work because of
the structural decline of the products value over time. Equally, a “short and hold” position on the VXX is like picking
up pennies in front of a steam roller. It only takes one volatility event to blow up your account.

Other issues exist for instruments like the VXX as well, such as being vulnerable to market marker’s manipulation,
the issuers themselves implementing things like “Redemption Features” which allows them to shut down the fund
should they wish to, without cause, and return the shareholders value at that point in cash. Trading the VXX is not
the same as trading the VIX. If you really want to trade volatility products it is very important to understand the
details of the products thoroughly.
At ITPM, we think that for the vast majority of retail traders it is not worth the trouble. There are plenty of other
ways you can take advantage of volatility in the market, and definitely other ways you can hedge your positions and
your portfolio – these concepts are taught in our various educational courses.

Of course, it is possible to make money from Volatility related products, but unless you have a very good
understanding of both market dynamics and the products themselves it isn’t going to end well. That being said
volatility strategies are something that can be covered during ITPM mentoring programs, where we discuss the right
conditions under which these trades can be viable.