Are volatility ETF strategies broken?

Updated: May 2, 2019

Trading the various volatility products such as XIV and VXX is becoming more and more popular with each passing year.  Not a day goes by these days that I don’t see an article or two written by a so called financial expert telling people how easy it is to profit from volatility.  To hear them tell it, you just buy the XIV when markets are stable, buy the VXX when they aren’t, and you laugh all the way to the bank.

This overly simplistic view of how these products are to be traded may get a lot of page views and get people excited about the prospects of profiting from a new method of trading, but it glosses over one very important fact.

Volatility trading is extremely complicated and the vast majority of people who trade these products will lose money doing so.  I don’t just mean inexperienced traders either.  I have competitors in the volatility space who have seen their accounts blow up in recent years, retreating in value back to levels previously reached three to four years ago.  As they have learned the hard way, one bad year can erase several years of gains.

First of all I have to say that I have a lot of respect for the great work being done over at Volatility Made Simple.  I’ve referenced and linked his business several times over the years simply because there are few people in the volatility space that have such a thorough understanding of the VIX Futures Term Structure and how these volatility products move around.  I’ve talked about many of the same things here but I do feel it’s important to get information from several different sources which is why I will continue to link to my competitors businesses in the future.  I especially like how every month he breaks down the performance of all the various strategies the blogosphere has put forward to trade volatility.  It becomes clear after reading that there are quite a few different methodologies being implemented by traders around the world.  Some strategies perform reasonably well, and others are complete disasters.  Very interesting stuff and I recommend my readers check out his blog because there’s some great insight there.

Let’s take a look at the results for the past four years from Feb 2012 through Feb 2016:

Everybody is a genius in a bull market

As you can see in the chart, our Volatility Trading Strategy, his Volatility Made Simple strategy, as well as the XIV buy & hold all performed well during the very strong bull market phase from early 2012 through mid 2014.  During most of that period the VIX futures term structure was in contango and we simply held the XIV and rode it up to relatively easy profit.

But around mid 2014 something happened.  Markets stopped cooperating.  They didn’t collapse, but they started giving mixed signals.  The VIX futures term structure was no longer as easy to read.  The spread between the VIX and the VXV narrowed.  The Volatility Risk Premium was ambiguous.

As a result, it’s been a bloodbath to say the least.  Traders everywhere have been blindsided by this new volatility environment that seems to be breaking all the old rules.  It’s left many scratching their heads wondering whether it’s even worth it.  As you can see in the chart, even a very seasoned volatility trader from one of the most respected blogs out there had a fairly difficult time staying in positive return territory in the past four years.

This phenomenon of big returns followed by even bigger collapses is something I’ve talked about at length and will continue to do so.  Our strategy is conservative in nature, only taking trades roughly 50% of the time.  When signals are ambiguous, we remain in cash waiting for more clarity and because of this our results are vastly superior.  In strong bull markets it’s certainly possible we may get outperformed by some of our more aggressive competitors.  But like death and taxes, something that is a guarantee is markets don’t always go up and they don’t always cooperate.

I hope nobody out there is swayed by impressive bull market gains.  If they are, why bother trading complicated volatility products at all?  Just buy a leveraged S&P 500 ETF and have fun.  The reason we trade volatility products is to design strategies with math based rules that will profit in both bull and bear markets.

We’re in this for the long run.  It’s true that markets have not been kind in past 18 months and its certainly understandable why so many people are down significantly in that time period, but this is going to happen many times in the coming years.  Navigating difficult markets like this current one is our specialty and it’s what separates us from the crowd.

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