September 18, 2017
In our previous blog post, we discussed why holding VXX and UVXY for long periods of time can be a costly mistake. We learned that contango and roll yield are the primary reasons why VXX and UVXY will eventually decay to zero (this does not happen because the ETPs reverse split, on average, every year and half to two years).
A common misconception among new volatility investors is that XIV makes money because of contango. Contango is the percent difference between the first and second month prices of the VIX futures term structure. The term structure is in contango roughly 70% of the time, often looking like the term structure below, but this does not necessarily mean that investors will see an increase in the price of XIV. Contango is merely an insight as to how XIV might perform and should not be a sole indicator to enter an XIV trade. The reason for this herein lies with roll yield, but before we talk about roll yield we need to understand how the XIV ETF works.
XIV- XIV buys and sells month one and two VIX futures contracts (XIV shorts volatility). XIV seeks to maintain a 30 day average VIX futures position. This means that each day, the weights for each month must be changed so that it may replicate said 30 day average. For instance, if there are 30 days till expiration for the first month futures at market open, then overnight, XIV will allocate more weight to the second month and decrease weight to the first month. This makes up for decreasing time until expiration and thus resets the average back to 30 days. XIV is adjusted every night after market hours.
Roll Yield- XIV is shorting holdings that are selling first month contracts and buying second month futures contracts. Note; however, that this buying and selling of futures contracts has no influence on XIV’s price. The money maker for XIV is roll yield. Futures contracts must settle at the spot VIX price. As we know, XIV’s synthetic expiration date must average to 30 days. After each trading day, the average number of days until expiration decreases. Assuming the price of VIX remains constant, the futures contracts will “roll down” to spot VIX price at expiration. XIV recognizes this gain each day as the contracts lose value; remember, XIV is short volatility so we gain when contracts decrease in price.
We stated earlier that contango is merely an indicator of possible XIV price increases. The term structure below demonstrates that XIV can still lose value while the term structure is in contango. Notice that the front two futures contracts are priced below the spot VIX price. Again, assuming that the VIX remains constant, these contracts must now roll up to the spot VIX price. XIV is short volatility, so XIV investors will face draw downs when futures contracts increase in price.
