Negative SPX/VIX Correlation, Predictor or Not?

Economist Eric Falkenstein, whose blog I follow religiously has a post about correlation between SPX and VIX. He writes that this correlation "...seems mainly a contemporaneous pattern applied to changes in volatility, spilled milk as opposed to a predictor. Think about when volatility was rising in 2008, and prices were falling simultaneously. The rise in volatility was not predicting price moves, just reflecting them, and the high volatility correlated with both the big move down and the big rebound in the latter part of 2009. " He addresses findings from another researcher, and there are interesting points raised in comments. In my own trading I do not use VIX, implied volatility, realized volatility or volatility forecast as indicator of market direction, because of their poor forecasting ability. See also my previous post on SPX/VIX correlation.

XIV - Your Questions Answered

I received a number of follow-up question to the XIV post. While I cannot share the data for the underlying index (per data subscription agreement) I'll explain the methodology in detail. Here is the sample spreadsheet that you should reference.

Sheet1 has four numerical columns, everything is done in google docs - so all this is very basic. The first contains values for SPVXSP index, which is the underlying index for VXX but without the costs and interest. Their effect is minimal in comparison to volatility of underlying index.

The values for SPVXSP index are in 90K range, that is because the starting value of the index is 100K. It is just a number and really does not matter that is it unusually high. In the second column I calculate simple returns for the index, third I calculate the inverse return by multiplying return by negative one. In the last column I apply inverse returns to get prices, with starting value equals $100. Again, all is very basic.

The table of monthly returns for the simulated index are on Sheet2. You may notice a large difference between simulation and actual XIV performance in the first month - that is only because the dates are different, and actual XIV has one less day than simulated version.

How risky is XIV? I apply bootstrap to monthly returns to find that there is about 60% chance that XIV will be up after one year, and 20% chance that it will more than double in price. This is of course contingent on previous return distribution to be true in the future, which we have no way of knowing. These results are of course excellent. On the downside there is about 12% chance of losing more than 50%, and expected maximum drawdown is 37%.

What is surprising to me is that return distribution is clearly positively skewed despite being a short-vol strategy. If you have any thoughts on this, please share or leave a comment.

Now let me clarify even though I think that XIV is a good product I don't plan on investing in it, because I think for me as a full-time trader it is far better to trade and actively manage risk than it is to buy and hold. You should decide for yourself if the product fits your investment objectives and risk tolerance.

Interesting VIX article

This one is Merrill Lynch guide to VIX futures and options, a research note that dates to December 2008, right after the credit crisis. Although dated, it contains a lot of info that I have not seen elsewhere. There is a very thorough introduction to empirical properties of the VIX (in the appendix), such as negative nonlinear correlation with SPX, and nonlinear "premium" of long-term futures contracts over short-term once, as well as relationship between short and long-term futures.

The main part of the document has an excellent exposition of different alpha strategies in VIX derivatives, as well as comparison to CBOE strategies indexes VPD and VPN. Over the testing period " Short VIX derivative positions would have offered higher returns and lower risk than the S&P 500. Despite the significant spike in volatility over the backtesting period, the returns of the short futures (-5.4%), short calls (2.0%), and short capped futures strategies (-3.8%) were all higher than the S&P 500 (-12.0%) ... All three strategies had nearly half the risk of the S&P 500 (25.6%), varying between 9.2% and 13.6% "

World Map of Volatility, Updated

Single Country Volatility Indexes (+Bloomberg Codes)

CITJTVIX:IND - Taiwan Volatility Index, one of the Asian volatility indexes developed by citigroup
INVIXN:IND - India VIX
RTSVX:IND - Russian Volatility Index
SAVIT40:IND - South Africa Volatility Index
SPAVIX:IND - Australia, also known as XVI. As I blogged earlier ASX has concrete plans to launch futures on the index
V1X:IND - Germany, also known as VDAX
V3X:IND - Switzeland, also known as VSMI
VAEX:IND - Netherlands
VBEL:IND - Belgium, has no data since November of last year, appears to be discontinued
VCAC:IND - France
VFTSE:IND - United Kingdom
VIMEX:IND - Mexico Volatility Index based on IPC, unlike others this is a 3 month index
VIX:IND - United States
VIXC:IND - Canada
VKOSPI:IND - Korea
VNKY:IND - Japan, Nikkei Volatility Index. There is also VXJ:IND but it is being updated every two weeks; VNKY is updated daily
VHSI:IND - Hong Kong, HSI Volatility Index. There is also ASCNCHIX:IND which averages implied volatilities of HSI options and FXI ETF options, so it is not a "pure" HK volatility as FXI also has currency risk. At this point there is no mainland China volatility index, since there are no listed options on A-shares.
VXEWZ:IND - one of the new CBOE volatility indexes based on ETFs, this one measures implied volatility of EWZ ETF. Unfortunately there does not seem to be any other Brazil volatility index at this time. Can Bovespa get its own vol index?

VIX Expiration and Forecasts

VIX settled this morning at 19.73, up 1.71 from May. VSTOXX closed at 23.23, up 0.87. Overall despite low volatility levels high economic uncertainly is priced in skew and term structure. My own forecasts for the next expiration are

• VIX at 19.71 vs 19.20 in futures
• VSTOXX at 22.79 vs 22.40 in futures

This is the first time that I recall my forecasts being so close to the market, and obviously makes for a challenging trading environment. As I wrote few weeks ago, I added a forecasts tracker page to the blog, where I record all the forecasts made here. The page has been updates with the settlement values, this month my models have outperformed market forecasts in terms of absolute error. I have also added signal and simulated PL for the futures columns.



Volatility forecasting contest that I announced few weeks ago is now closed. I was hoping for a better response, but I guess readers just afraid to be spammed. Still, I'm happy this way it turned out to be a close-knit group of readers. The forecasts range from 13.50 to 25.12, with average value of 18.12, and median value of 17.01. Using bootstrap I calculated the confidence of 0.70 (1 std) on the forecast, which is much much smaller than anything one would get by a statistical technique! (See the bootstrap of the forecasts below) I'm surprised that most of you emailed forecasts with cents component, as opposed to rounded to a dollar, which to me is an indirect evidence that people really put thought into their forecasts. Good luck, traders, and hedge your deltas!

RTSVX Futures Launched

RTS, the leading derivatives exchange in Russian Federation launched trading in futures tied to RTSVX - Russian volatility index. The futures started trading on the June 1st, and the first contract (June) expired last Tuesday. Although it is probably too early to tell, the contract seems to be a success - daily volume is over 100 and open interest in thousands. Press release (eng, rus).

What is really interesting about the contract is that it is denominated in USD, with one point equals to $20, such that minimal tick 0.05=$1 . Default expiration of the futures contract is seven days before RTS expiration. Contract specifications are available here.

Right now only two months are listed - July and September, but RTS will probably list more based on demand. Because the contracts are denominated in dollars, trading provides an interesting opportunity for statistical trading between RTSVX and VIX ( although with significant execution risk since trading hours don't overlap ) , as well as trading between RTSVX  and VSTOXX futures ( with currency risk between USD and EUR ) My hope is that the success of RTSVX will lead other world exchanges to launch futures on their volatility indexes, such as INVIX futures in India, and XVI / SPAVIX futures in Australia.

More details on RTSVX index calculation methodology are available here (eng, rus).

XIV - the first 6 months

XIV ETF has almost doubled since it launch about half a year ago. If you invested in the beginning and made a lot of money - congratulations! But the big question is: can we expect the same excellent performance from XIV going into the future? To answer this question I look at the SPVXSP index - the underlying for both VXX and XIV for the last 5 years. I take the values of the index and simulate hypothetical performance for the ETFs (starting values normalized to 100)

While the last half-year for the XIV have been excellent, XIV had a huge drawdown losing over 80% of its value at one point. In the five years since June 2006 to January 2011 XIV was flat, and despite its excellent performance in the past half-year XIV still would not have recovered from the drawdown.There is obviously a lot of risk in XIV that recent history does not account for. Geometric annualized return for the index (like-VXX) is -37.47%. Geometric annualized return for the daily inverse (like-XIV) is 12.77%

EDIT: See my new post on XIV.

More Commodity Volatility Indexes

CME announced that they will start disseminating two more volatility indexes - one for corn and another for soybeans. Current commodity volatility indexes are - GVZ/GVX for gold, OIV/OVX for crude, VXSLV for silver, and SAVI white maize index calculated by Johannesburg Stock Exchange. Since CME failed to generate any volume for their volatility contracts, and CBOE's recently lauched GVZ futures and options volume is still very small (and not growing) it is very likely that no derivatives will be listed on these instruments.
See more commodity volatility indexes here.

VOLT ETF / Voltage ETF Update

Since I've blogged about VOLT ETF few weeks ago, I was able to obtain official Nomura document about the product. The document is very thorough, explaining in detail  the phenomenon of positive correlation between vol of vol and volatility level. VOLT uses dynamic allocation, and trades (rather than invest) quite aggressively. Robustness of the strategy is also addressed by selecting different lookback windows for estimating vol of vol. Fwiw I would love to see the same analysis done using more efficient intraday realized vol of vol measures.

While it sees that the strategy is sound, and provides for a good hedge for a long portfolio, the strategy is complex and it is hard to estimate the potential of strategy failure in the future. My suggestion is if you're a trader to use the research (correlation between vol of vol and volatility) for your own strategies, and if you're an investor consider a small allocation because of the negative effect of the fees and trading costs.

Nigerian Stock Exchange WTF

Over the weekend I came across an article about Nigerian Stock Exchange introducing options and futures trading. While trying to find out more information I saw the following quote on the Exchange's website:

"Integrity is the watchword of The Stock Exchange. Market operators subscribe to the code “Our word is our bond”. Thus, public trust in the Nigerian stock market has grown tremendously ...  The Stock Exchange’s 39-year history is devoid of any fraud, shocks, scandals or insider dealings."

ORLY?

Week in Volatility

Markets fell, and VIX rose substantially on Wednesday. What is unusual that is week over week long-term futures were practically unchanged, slightly higher for VIX, and slightly lower for VSTOXX futures. GVZ volume is not growing - with zero futures and 40 options contracts traded in the last week. It also looks like the bid-ask spreads on GVZ options have widened since the contract listed. Oh well...

What do YOU think? Volatility Forecasting Challenge!

Every month, around the VIX expiration I publish my forecasts for the next month. This time I would like to do something different – for you to join me in this exercise. Email me your VIX forecast for July 2011 expiration before June 15th 2011, and if your forecast is the closest to the July official VIX settlement (VRO) I will paypal 100 USD to the winning email address.

The rules are simple: your forecast is a single number (not a range) for the settlement value of VIX (VRO) on Jul 20th , 2011. One entry per person, and I reserve a right to remove any entry that I consider to be suspect. Your email addresses will not be used for any communication from me, or given to a third party – I love my readers and do not intend to spam them.