VIX Exchange Traded Products: Price Discovery, Hedging, and Trading Strategy

• Author: Sven R. Samdal,Christoffer Bordonado,Peter Molnár
• Published date: 01 February 2017
• Date: 01 February 2017
• DOI: http://doi.org/10.1002/fut.21786

VIX Exchange Traded Products:

Price Discovery, Hedging, and

Trading Strategy

Christoffer Bordonado, Peter Moln´

ar,*and Sven R. Samdal

This paper investigates the most traded VIX exchange traded products (ETPs) with focus on

their performance, price discovery, hedging ability, and trading strategy. The VIX ETPs track

their benchmark indices well. They are therefore exposed to the same time-decay (high negative

expected returns) as these indices. This makes them unsuitable for buy-and-hold investments,

but it gives rise to a highly profitable trading strategy. Despite being negatively correlated

with the S&P 500, the ETPs perform poorly as a hedging tool; their inclusion in a portfolio

based on S&P 500 will decrease the risk-adjusted performance of the portfolio. ©2016 Wiley

Periodicals, Inc. Jrl Fut Mark 37:164–183, 2017

1. INTRODUCTION

Financial research has made great strides in understanding risk and volatility. In recent

years, the trading of volatility has also become widespread. A variety of volatility-related ex-

change traded products (ETPs) listed on several exchanges around the world exist to facilitate

volatility trading. For instance, one can trade volatility derivatives on the S&P 500, the Euro

Stoxx 50, Nikkei, emerging markets, oil, gold, and many other. These volatility ETPs allow in-

vestors to trade volatility without using options or futures, and therefore provide them access

to seemingly attractive hedging and diversification opportunities. However, many of these

products are structured in such a way that their long-term expected value is zero. Despite

this fact, the popularity and trading volume in these products continue to rise.

Whaley (2013) explains how and why many VIX ETPs are virtually certain to lose money

through time due to a “contango trap” in which VIX futures prices fall to the level of the VIX

index. Deng, McCann, & Wang, (2012) find that VIX ETPs are generally not effective hedges

for stock portfolios because of a negative roll yield. However, they propose that medium-term

ETPs appear to both reduce the volatility and increase the return of stock portfolios. Fur-

thermore, Alexander and Korovilas (2012b) point out that individual positions in VIX futures

ETNs, including mid-term and longer-term trackers, offer no opportunities for diversifica-

tion of equity exposure, except during the onset of a major crisis. However, they indicate that

certain portfolios of VIX futures, or their ETNs, referred to as “roll-yield arbitrage” portfolios,

can offer unique risk and return characteristics and diversification opportunities. Simon and

Christoffer Bordonado, Peter Moln´

ar, and Sven R. Samdal are at Norwegian University of Science and

Technology, Trondheim, Norway. We would like to thank Carol Alexander for the inspiration to investigate

this topic.

*Correspondence author, Norwegian University of Science and Technology, Trondheim, Norway. Tel:

+47 73593578, Fax: +47 73 591045, e-mail: peto.molnar@gmail.com

Received January 2015; Accepted March 2016

The Journal of Futures Markets, Vol. 37, No.2, 164–183 (2017)

©2016 Wiley Periodicals, Inc.

Published online 6 May 2016 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21786

VIX Exchange Traded Products 165

Campasano (2014) demonstrate that selling (buying) VIX futures contracts when the basis

is in contango (backwardation) and hedging market exposure with short (long) S&P futures

positions is highly profitable and robust to both conservative assumptions about transaction

costs and the use of out-of-sample forecasts to set up hedge ratios.

Eraker and Wu (2013) propose an equilibrium model to explain the negative return

premium for both VIX ETNs and futures. In this model, increases in volatility endogenously

lead to decreasing stock prices. The negative return premium is an equilibrium outcome

because long VIX futures positions hedge against low returns and high volatility states (i.e.,

financial crisis).

This paper provides a comprehensive analysis of VIX ETPs with focus on the perfor-

mance, hedging, price discovery, and trading strategy. The finding that the hedging ability

of VIX ETPs is rather poor is in line with Alexander and Korovilas (2012b) and Deng et al.

(2012).

To our best knowledge, this is the first study of price discovery between different VIX

ETPs. Since there exist different categories of VIX ETPs, we study price discovery between

the two most traded ETPs within three categories: direct, levered, and inverse. We find that

more traded and older ETP leads the price discovery process in case of direct and levered

ETPs, but less traded and younger product is the information leader in case of inverse ETPs.

Finally, we propose a trading strategy based on buying VIX direct and inverse ETPs and

hedging the position with S&P 500 ETF. This part of our work is related to Alexander and

Korovilas (2012b) and Simon and Campasano (2014). However, even though Alexander and

Korovilas (2012b) study VIX ETPs, the trading strategy they study is different than ours.

Our strategy is mostly related to Simon and Campasano (2014), but they use VIX futures as

traded instruments. Our result is different than theirs, we find that an unhedged version of

this strategy is the most profitable.

This paper is organized as follows: Section 2 explains the VIX ETPS and presents

the data. In Section 3, the price discovery relationship between different pairs of ETPs

is studied. Section 4 investigates the hedging ability of the VIX ETPs when included in

an equity portfolio tracking the S&P 500. In Section 5, a trading strategy using direct and

inverse VIX ETPs is proposed. Section 6 concludes.

2. DATA

The S&P 500 index is often considered as a representation of the U.S. stock market, because

it covers more than 80% of the U.S. stock market. The VIX index measures the implied

volatility of S&P 500 index options. The VIX is often considered not only as an expectation

of market volatility, but also as an indication of investor sentiment. The time development

of the VIX and the S&P 500 is plotted in Figure 1. The spikes in the VIX quite clearly

correspond to price drawdowns in the S&P 500. From 1990 to 2014, there has been a

correlation between the daily returns of the VIX and the S&P 500 of approximately −0.71.

The overall tendency of volatility to increase when prices fall is evident in Figure 1.

While the VIX is not a traded entity itself, there is a market in VIX futures and options.1

Tradingof VIX futures began in March 2004 and VIX options in February 2006. VIX exchange

traded products (ETPs), the second generation of volatility products, were introduced in

2009. ETPs are traded on a securities exchanges. Exchange traded products include exchange

traded funds (ETFs), exchange traded vehicles (ETVs), exchange traded notes (ETNs), and

1See http://www.cboe.com/Strategies/VIXProducts.aspx