Adam Warner, contributor to Schaeffer’s Research, explains how a new volatility product offers traders a viable alternative when trading option volatility…but there are notable drawbacks, too.
We’ve harped about a billion times about the structural issues that plague the iPath S&P 500 VIX Short-Term Futures ETN (VXX). In order to maintain a strict 30-day VIX futures (or swap) duration, it must necessarily roll out in time each and every day. But if the VIX futures curve slopes upwards, VXX loses money each and every day it has to slide out in time by selling shorter-term VIX paper and purchasing longer-term VIX paper. And since the VIX curve virtually always slopes up, VXX almost always swims uphill.
Is there a way to produce a short-term proxy for CBOE Market Volatility Index (VIX) futures while mitigating this almost permanent cost?
Well, JPMorgan Chase (JPM) is taking a stab at it with a proposed product called the "JPMorgan Macro Hedge Index." If you have access to a Bloomberg machine, you can track it at JPMZMHUS. It’s based on their very accurate premise that volatility spikes "tend to be large in magnitude, tend to occur infrequently, and tend to mean-revert over time."
VXX owns some time-weighted combo of first- and second-month VIX futures (or equivalents) and rolls out each day to maintain duration. The JPM Index will attempt to produce a similar effect by owning the front-month and third-month VIX futures and "opportunistically" shorting the second-month VIX future.
That opportunistic short will stay on in low-stress, upward-sloping VIX futures markets based on defined criteria (they call it the "three days robustness test"). They propose to open/close the VIX futures short in 20% increments, as their rules dictate.
So, what’s it all mean?
In "normal" low-stress times, the JPM Index will own a VIX time butterfly: long the first and third month, and short the second month. It will roll by purchasing the second month and selling the third month, thus generating small, positive returns in a normal, up-sloping curve.
When stress hits, JPM scales into covering their futures short, and subsequently, the vehicle will behave similarly to VXX.
On the plus side, you get exposure to a volatility long without the perpetual drag that VXX suffers, and since we spend most of our time in a low-stress backdrop, that’s a good thing.
On the con side, you’re going to miss the beginning of any volatility spike. That may prove costly, as we get some sudden and stunning turns in the volatility markets. The JPM Index may finish scaling back their VIX futures short just in time to watch the volatility spike end. Think of it as owning VXX and running a VIX futures short against part of it, and then stopping out that VIX futures short into spikes. That puts you at risk of some horrible slippage.
What happens if a large gap up in VIX futures triggers a cover of the VIX future short? The JPM Index will have to cover at way more unfavorable prices than any hypothetical model will suggest.
What’s more, suppose this product takes off and supplants VXX as the most popular VIX-based exchange traded note. They run the risk of causing their own VIX futures melt-up by their need to chase it into a strong rally. And traders/hedgers will know this demand is coming, and perhaps buy VIX futures ahead of JPM.
I do like the concept of this product. You can’t actually hold VXX over time; you can only pick your spots and trade around it. From the sounds of it, you could actually hold this JPM product as a portfolio hedge. I just worry that in reality, it will both face—and cause—some unintended consequences.
See related: The Newest Innovation in SPX Options
By Adam Warner, option trader, contributor to Schaeffer’s Research
