Leveraged ETF Volatility Decay Explained - UVXY | SVIX | SVXY

Video Transcript:

So remember there are actually only two forces that are affecting the price of the volatility ETPs. The first one from my last video was called roll yield which accounts for the changing value of the actual VIX futures that all of these funds are holding. The second which we'll talk about today is called beta slippage and beta slippage affects all of the volatility ETPs that use leverage.

Now of course that obviously includes UVXY and the UVIX but something that many people don't actually consider, the inverse volatility products like SVXY, like SVIX, they also suffer beta slippage. Remember this applies to any security with a leverage factor so let me show you what I mean.

So let's start with a very basic definition here.

Beta slippage which you may also hear as beta decay, volatility decay, volatility drag, the gearing effect, these all mean the same thing. It's a multi-day price tracking inefficiency present in leveraged ETPs caused by the mandated daily rebalancing. Now that's a lot of words but we can actually just see the beta slippage when we go through some real examples.

So here we've got a table with all the main volatility ETPs listed along with their leverage factor. Now the VXX is the baseline because there is no leverage involved it's just a one times long volatility product and I am going to exaggerate that movement so we can illustrate it but just know that even smaller movements will have that beta slippage present. It'll just take longer than four days to see it.

So for the baseline VXX we show it going up 10% on day one, down 9.09% on day two, up 10% again on day three and then finally down 9.09% on day four. A four-day round trip and the price has not changed. Now if you're wondering why I'm not saying up 10% and then down an equal 10% that's just because of the mathematical drag that losses are always more costly than gains are beneficial.

Remember if you take a 10% loss it takes more than a 10% gain to get back to break even. It actually takes 11%. If you suffer a 20% loss it takes 25% to get back to break even.

To get the non-leveraged baseline VXX breaking even after four days we are using a slightly smaller loss than gain but with geometric compounding they are the same. So now let's do the exact same daily price changes for the 1.5 times leveraged UVXY. Now you can see there will be some beta slippage.

After that four-day round trip it's actually lost a little bit of value. Remember all of the volatility ETPs regardless of leverage they all do a little bit of rebalancing to transfer a little bit of the M1 VIX futures towards the M2 VIX futures. That part of the rebalancing is all done at a net zero transaction no price change occurs.

But for the leveraged products they also have to rebalance for that leverage factor as well so they can start the next day at the intended market exposure that matches their leverage factor. That's the gearing effect we're seeing here. There's a tracking error involved so if we amplify the leverage more now and use the two times UVX now you can see the four-day price change is even more significant and it's not just a linear increase either. There's actually two exponential factors here. First the more leverage the ETP has the more exponentially that beta slippage will affect it and secondly the more day-to-day volatility they experience the more exponentially extreme that beta slippage will be.

The higher the leverage factor and the more day-to-day volatility we experience the more that beta slippage will affect the product. But now let's look at the interesting case of inverse volatility ETPs SVXY and SVIX. They may not look like traditional leveraged funds because they're negative but remember they also do a daily resetting to start the next day with the proper exposure.

The minus 0.5 times SVXY going through the same four-day period as before it will lose value due to that beta slippage and notice the amount. The minus 0.5 times short SVXY has the same inefficiency as the 1.5 times long UVXY. The beta slippage here has nothing to do with it being a volatility product.

The exact same beta slippage occurs if you're talking about leveraged stock market ETFs. Natural gas, precious metals, crypto, whatever it this is a mathematical gearing effect caused by the leverage itself not the fact that it's a volatility product. If we go to the minus one times inverse SVIX now we can see after four days the beta slippage is more than twice as bad as the SVXY and it's actually the same as the two times long UVX.

If we plot these on a chart you can see visually that inefficiency. Starting with the baseline VXX of course it's bouncing around the center line. The 1.5 times leveraged UVXY though it's lost a little bit of its value after four days due to beta slippage.

The UVX stretched out over time it's going to have exponentially more beta slippage. Now it is important to note here that beta slippage itself doesn't always negatively affect the product. If for example you went through a short-term period where it's mostly up days and very few down days then that leverage could actually boost the returns in the short term.

You can have periods where a three times leveraged version of a stock market ETF for example it might actually perform better than three times the underlying non-leveraged index. That leverage can help for shorter periods of time. But when you stretch it out over longer periods that include both good and bad trading days that's when that higher volatility and the leverage factor with daily rebalancing they combine to make the beta slippage a net negative long term.

So now you understand beta slippage and the VX30:VIX role yield both factors affecting volatility ETPs.

So now you're ready to start making some real money shorting volatility with our main Tactical Volatility Strategy that you can learn all about right here.

See you next time.