Wednesday, September 21, 2011

The upside with XIV

As I mentioned in my last post there is a lot of downside risk investing in XIV.

But how much upside can you get?

Everybody who trades volatility products should know about the contango in the volatility term structure (you shouldn't invest in volatility products if you don't know what this means). This contango is the driving force behind the expected long term positive performance of this product.

As I backtested the XIV I came up with 3 different market environments:

1.) Stable and low (VIX below 25) volatility environment.
For example between 2004 and 2006 volatility was very low, VIX fell below 10 for a few days. The average contango in the volatility futures was 7.7% (the second month VIX futures was 7.7% higher than the first month one).
During this time period the XIV would have had an average return of 9% per month with a 10.4% monthly standard deviation.

2.) Rising and high volatility environment
During 2007 and 2008 the volatility was rising due to the credit crisis and the VIX reached 80 in late 2008. On average the volatility term structure was close to flat.
XIV would have had an average monthly return of -2.9% with an 18% volatility.

3.) Falling volatility environment
Between the beginning of 2009 and July 2011 the volatility came down to more normal levels. The average contango was 7.4%. The average monthly return would have been 11% with a standard deviation of 14.7%.

Obviously XIV is not a good investment is raising volatility environments but can be a very good one in falling or stable environments.

Even after the recent 50% drawdown the XIV would have produced a 69% annual return since March of 2004. That is an impressive return given the annualized standard deviation of 55%.

An investment with 55% annualized standard deviation and significant skewness needs some serious risk management. More on that in my next post.

Disclaimer: No statement within this blog should be construed as a recommendation to buy or sell a security or to provide investment advice.


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