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In a strong move of nearly 4% in a day, it appears that the ProShares Short VIX Short-Term Futures ETF (SVXY) may be putting in a bottom on the anticipation of volatility subsiding. It is my view that despite the rally in shares today, buying SVXY at these prices still represents a bargain and that further upside is highly likely in the near future.
The Instrument
When analyzing volatility ETFs and ETNs, I believe a good deal of time should be spent examining what it is that you’re actually trading or investing in. This simple due diligence process can often help prevent unexpected results, especially in the volatility space where much nuance goes into every instrument.
In the case of SVXY, it is an instrument which provides a half-leveraged return of the inverse of the S&P 500 VIX Short-Term Futures Index. There’s a lot here, so let’s unpack this.
First off, the S&P 500 VIX Short-Term Futures Index is an index provided by S&P which gives exposure to the VIX futures market. How the index works is that it gives the return as though it maintains a constantly rolling exposure across the front two contracts of CBOE’s VIX futures. VIX futures are cash-settled contracts provided by the CBOE which settle based on what the VIX was calculated at in a certain window. The VIX itself is a calculation of implied volatility from options on the S&P 500 which settle 30 days in the future and it represents an annualized number. For example, the VIX is currently at 16.88, which means that the market is pricing options on the S&P 500 at such a level that an option-pricing model would show the implied volatility is an annualized 16.88% in the S&P 500.
The reason why we walked through all of this is pretty simple: it matters. The reason why this matters is that first and foremost investors should know while they are buying or selling SVXY, they are not actually trading volatility – they are trading an index that rolls futures which settle off of a calculation from an options pricing model. At each step in this process, specific factors can influence the actual return of the ETF which have nothing to do with the actual level of volatility in the market. For example, if a trader were to put on a massive position in the specific contracts which are used to calculate the VIX, the implied volatility of those positions would likely increase and thus increase the VIX itself which in turn would influence the price of the futures contracts which track it. There are plenty of other examples and nuances which go into the return of SVXY, but perhaps the most important of which is roll yield.
When it comes to trading volatility, it really pays to start with a mindset of mean reversion. What I mean by this is that when volatility increases, it tends to fall in the future and when it falls, it tends to rise in the future. To see this relationship in force, here’s a simple chart of past volatility versus future volatility in realized volatility of the S&P 500.
As you can see, volatility tends to mean-revert. I could play around with the inputs and show the relationship across different time frames, but there isn’t too much point in that mean reversion dominates almost every time window in volatility.
How mean reversion plays into roll yield is that it means that since there is basically no long-term drift in volatility, as time progresses most of the return of strategies which roll across VIX futures will be heavily influenced by roll yield rather than any underlying changes in the VIX.
Put simply, roll yield is the general tendency in forward curves for the prices in later months to trade towards the front of the curve as time progresses. For a good graphic that explains this relationship, I’d suggest this Wikipedia image.
When a market is in backwardation (front contract priced higher than back-month contracts), roll yield on a long position will be positive because the position held at lower prices will trade up in value towards the front-month contract as time progresses. For a market trading in contango (front contract under back-month contracts), roll yield on a long position will be negative because the position established at higher prices will generally drift lower to approach the front-month contract as time progresses.
Since volatility essentially travels nowhere over lengthy time frames (largely caught between 10-20% over many decades), this means that this rolling process in VIX futures is largely the determinant of the return of SVXY (which gives a half-leveraged return of rolling a short position of the index). Here is the current forward curve of VIX futures:
At present, the market is currently caught in contango. This means that since SVXY is rolling a short position, roll yield is currently positive and therefore shares are going to be generally drifting upwards. As long as the market remains in contango (which has largely been the case for many years) roll on a short position will be negative and shares of SVXY will tend to increase.
Another key factor influencing return is the fact that volatility is likely to continue decreasing due to the nature of mean reversion. There are a number of different ways to quantify this, but I prefer the more simple methods. For example, over the last 3 weeks (time since this selloff in the S&P 500 began), the VIX has increased by about 6.3%. Historically, there have only been 22 3-week periods where VIX has shot up this much or more and of these 22 only 8 were higher over the next month. History doesn’t repeat itself perfectly, but it tends to rhyme. In other words, there’s probably only about a 22% chance that volatility will be higher a month from now which means that holding SVXY makes for a solid trade.
Shares of SVXY are currently poised to capture upside due to the fact that volatility is reverting to the mean and the roll has now switched positive for the ETF. On this basis, I recommend holding SVXY either on an outright basis (preferably with a deep out of the money call option as downside protection) or through a form of option spreads.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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