This is a question that has come up a lot recently and I wanted to do a short explanation here. I plan on doing a more extensive article on this later which will be featured on my SeekingAlpha page.
Let's say that currently VIX futures are in 7% backwardation.
If we break this down here is what affect that would have on an inverse volatility product:
- 7% value loss over a period of one month as futures roll from the second to the front month contract.
- There are typically around 21 trading days per month.
- 7 divided by 21 equals 0.33%
Your daily drag from backwardation would average around 0.33%.
Now, let's say that the VIX futures (front and second month) fall 1% during the trading day. This would leave a theoretical gain of 0.67% minus any fees of the fund or deviations from the NAV.
Long story short:
If the VIX futures fall faster than the rate of backwardation, inverse volatility products will go up. This is also true for long volatility products when volatility futures rise faster than the rate of contango.
I just wanted to clear up a common misconception I have seen lately.
Have a great week. I should have an article published on SeekingAlpha either today or tomorrow.
Hi Nathan, Always big fan of how you can explain VIX to layman investors like me. Is there a way to back calculate what XIV would have been in case of a recession based on VIX values? (example from 2007 to 2009 when SPY was cut down by half?). I could not find XIV data going back before 2010. Thanks.
ReplyDeleteThanks for reading! SVXY and XIV are nearly identical. I have backtesting on that here: http://seekingalpha.com/article/2250783-how-uvxy-and-svxy-would-have-reacted-in-2008-and-2011 Let me know if that doesn't answer your question.
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