By Eric Bush
Trying to play pure volatility as a retail investor is tough. Not only can you not invest directly in the widely watched VIX, but ETFs that attempt to track the VIX end up with a substantial tracking error. This occurs because volatility ETFs such as the ProShares Vix Short-Term Futures ETF (VIXY) track an index made up of VIX futures. When future prices are in contango (as is usually the case for VIX futures), this creates a negative roll yield that eats away at the ETFs price. Over the past four years, VIXY is down 58.6%. The iPath S&P 500 VIX Short-Term Futures ETN (VXX), which tracks the same index as VIXY, is down 58.5%. Out of 1081 ETFs that have at least four years of trading history, VIXY and VXX have had the 6th and 7th worst performance over the past four years, respectively. With that nasty backdrop the silver lining is that for the first time in quite a while there are indications that pure play volatility investments could begin to pay off.
In general, greater volatility in one segment of the capital markets tends to lead to overall greater levels of volatility in all segments of the capital markets. For example. a month ago junk bond spreads widened out to multi-year highs and look to be on the verge of making new highs very soon. As the chart below shows, greater volatility in the bond market tends to coincide with greater volatility in the equity markets.
Volatility among major currency pairs has also been substantially higher in 2015 than the majority of the last several years. FX volatility has been pointing to increased equity volatility for quite some time.
Equity volatility in other parts of the world is on the rise. The VDAX, which is similar to the VIX but for the German equity market, broke out to a multi-year high a month ago.
Macro risks around the world are on the rise. The Citi Macro Risk Index “measures risk aversion in global financial markets”. It tracks various CDS spreads, credit spreads, swap spreads and implied volatility across FX, equity and swap rates. As this index rises, the perceived amount of risk in the global financial system increases. After falling for most of the year, this index is sharply higher over the past six weeks.
Finally, on a relative point and figure basis, both the VIXY and VXX have recently broken though a firm resistance line that has been in place for four years and they both seem to have been in a basing formation for about the past 18 months. If this base can hold than there is a tremendous amount of potential upside for VIXY and VXX.