When will XIV trading strategies underperform?

by | Apr 28, 2016

At Volatility Trading Strategies we’ve been very successful at navigating the complex world of volatility products and we have the highest conviction that will continue for years to come.  However it’s always a good idea for traders to understand and acknowledge potential weaknesses because no system is immune to drawdowns.  It keeps our egos and expectations in check and reminds us that although something is working today that doesn’t necessarily mean it’s going to work tomorrow.  We spend a lot of time analyzing results from unsuccessful trading months.  This helps us fine tune our strategy to make sure it’s consistent and remains profitable for many years to come.

There are two market environments where our VTS Tactical Volatility strategy may underperform:

 

1)  When the VIX is rising, but in a somewhat calm and orderly fashion. (the “slow bleed” as we call it)  It is entirely possible for the VIX itself to be rising while the VIX term structure is still in Contango.  In this type of market environment the XIV will lose value and drop in price.  A good example of this was in May of 2012.  The VIX rose from the 16% level all the way up to the 26% level yet the entire time the VIX term structure was in Contango.  Check out the following charts of that 32 day period:

We track several different market indicators and they all need to flash a buy signal in order for us to actually take a trade.  Most of the time when we see this market of the VIX rising slowly but still in Contango we get a signal somewhere that tells us to move to cash and avoid taking losses.  However this isn’t always the case.  In that March of 2012 example above we were in the trade for some of those losses because for most of that month everything else was flashing a normal market as well.  We learned a lot from this trade and now have an additional filter to help catch the signal a little earlier next time.

 

2)  An unexpected spike in the VIX Index.  Since XIV derives its price based on the VIX futures term structure, any sudden upward spikes are going to show up in the price of XIV itself.  There are a number of things that can cause the VIX to suddenly spike.  Natural disasters like the Japanese earthquake in 2010 was one of them.  Any type of international incident, maybe a declaration of war or a sudden terrorist attack would be another.  One of the most pronounced VIX spikes we’ve seen was during “The Flash Crash” of 2010.  In a span of just minutes the VIX Index spiked from the mid 20’s into the low 40’s before settling back down.  This would have caused the XIV to drop about 17% in just one trading day.

Now of course there isn’t anything we can do about black swan type events, which is why they are known as black swan events, but at least we can rest easy knowing that when they happen it will certainly trigger some of our indicators to move to cash as quickly as possible.  If the XIV ever takes a nose dive in a single trading session regardless of what the cause is, it’s often best to just exit the position and wait for things to settle down a bit.  Although in the short-term these events can have a significant impact on returns, due to our strict focus on risk management and willingness to quickly move to cash, these types of events don’t seriously impact our long-term results.

Aside from those two situations our VTS Tactical Volatility strategy is exceptional at staying ahead of the markets and predicting when the XIV or VXX have mathematical tail winds and high probability of success.

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