I’m pissed. I mean, I’m really pissed. I bought an investment in September that I just sold this week at a 25% loss. Now, I’m not pissed that I lost money on the investment. People lose money in investing all the time that’s part of the game. I am pissed because the investment that I thought I bought wasn’t the investment at all.
In September of 2019, I predicted that the VIX, often referred to as the volatility index, was trading at a discount. I knew that I could not buy the VIX directly since it is a mathematical equation, not a stock. So I bought what is called an ETF (an exchange-traded fund that holds a basket of securities). This ETF is constructed to “mimic” the performance of the VIX, and after running a correlation analysis, I saw that the ETF had a correlation coefficient of .93 (93%). I thought, “great!” I put in the order and sat back and relaxed. I knew it wasn’t a 100% correlation, but how far off can 7% be really.
The Power of 7%
The correlation coefficient is a statistical measure of the strength of the relationship between the relative movements of two variables. For example, a correlation coefficient could be used to calculate the level of correlation between the price of crude oil and the stock price of an oil company. If every time a barrel of oil went up $1 the oil-producing company went up $3 that would be a correlation of 1.0. Perfect correlation. Every time one goes up, the other goes up. So if you were long oil, investing in this oil company would seem like a great bet.
Now take this scenario. Imagine every time a barrel of oil went up $1, the oil-producing company went up $3, but every time a barrel of oil went down $1, the oil-producing company went down $6. This is still a perfect correlation since every time one variable goes up, the other goes up and vise versa. However, if you were long oil, you’d be better off buying a futures contract for oil, seeing that if you bought the company oil would have to go up $2 every $1 it lost, to break even.
Why You Never Bet on Volatility through a Vix ETF
On September 16th, 2019, the VIX closed at $14.67. The VIXY, the ETF that is supposed to track the performance of the VIX, closed at $19.25. As of February 25th, 2020, the VIX closed at $27.85. The VIXY closed at $15.54. The VIX gained 90% while the VIXY lost 20%. One hell of a correlation, huh?
So, how did this happen? To understand this, we need to understand what precisely the VIXY does to track the VIX. Remember, the VIX isn’t a stock. It’s a mathematical equation. While the equation is intimidating, all it represents is the market’s expectation of 30-day forward-looking volatility. Therefore the higher the expected volatility, the higher the index.
There are only two ways to bet on volatility. One, you can purchase a futures contract, a contract that states you have to buy or sell a security at a predetermined price at a specified time in the future. Or, you can buy an ETF, which buys and sells groups of those futures contracts and puts them in a basket that you can invest in. While they both carry a great deal of risk, the latter carries a more substantial risk to long term investors.
The VIXY ETF works by buying expensive, longer-dated contracts while selling cheaper, short-dated ones. This cycle effectively leads to buying high and selling low, the complete opposite of what investors want to do.
The VIX is almost always in a state of Contango (see image for visual). Contango means that the futures contracts that are farther out in time are more expensive than the current price. This makes sense since it is much easier to predict what will happen next month than what will happen a year from now. However, while in Contango, the futures price will decline to the current price upon the expiration of the contract.
So How Can You Win?
The best way to invest in volatility is directly by buying a futures contract. Full disclosure, I have never purchased a futures contract myself, however by purchasing a futures contract, you are guaranteed to mimic the performance of the VIX and not worry about downward pressure that you may experience through an ETF.
If you don’t want to get caught up using leverage and risking a significant position, then you can use a VIX ETF. However, you have to make sure you are super short term. By short term, I mean a holding period of ideally no longer than 30 days. This can get difficult because calling anything in finance within 30 days is a fantastic feat, and if you could consistently do that, you’d be a millionaire many times over.
Imagine if instead of buying AAPL, the ticker symbol for Apple Inc., you bought APLE, the ticker symbol for Apple Hospitality, a real estate holding group. You’d be upset, especially if AAPL went up 100%, and APLE went down 25%.
The thing is you can still celebrate. Even though you bet on the wrong security, your hypothesis was correct. I was right about the VIX. I just happen to invest in the wrong vehicle. As the old saying goes, “You either get richer, or you get smarter. Never both.”