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How the Volatility ETNs Broke the Market

The gig is up.

The disconnect is obvious.

And there's a way to profit from it.

Read on to see how.

The Volatility Landscape

When we view volatility, we can look at the past through Historical Volatility, or we can look in the future using Implied Volatility.

HV is what has happened, IV is what the market is pricing in.

We've seen how HV is pretty low right now. But IV is still at a steep premium relative to how the market is trading.

It's even worse when you look at volatility futures:

The Retail Problem

It's well known among professional option traders that using VX futures as a way to hedge option positions is a very powerful technique.

But it's not made for retail.

Each VX contract requires about $5,000 in margin, and they are rarely available on retail trading platforms.

So what do we do?

Make a tradeable index, of course.

What could possibly go wrong?

The ETNs Broke the Game

Let's look at some other examples first.

We have $TZA. This is the Diorexion Daily Small Cap Bear 3x index.

If they want to create more shares, they can simply go out and pick up more swaps, which are fully arbitrageable in the market.

You can easily hedge against this position using TF futures or by trading a basket of stocks.

You can't do that with VIX instruments.

I've said this damn near 400 times: the VIX is not tradeable.

It's a statistic.

The statistic is based off a basket of SPX options that changes every time.

It's impossible to create a grouping of options to arb against any vehicle creation. There's no easy arb when creating index instruments.

On top of that, VX futures don't track spot VIX, although they converge over time.

The Problem Child

And we also have this $TVIX. It's the Daily 2x VIX Short Term ETN.

What happens with short term volatility ETNs?

They get into short term VX futures.

And then they have to roll them.

If the mid term future is priced higher than the near term, there is a cost to this roll.

And just recently, the volume has come in:

So you've got an instrument that is a leveraged derivative of a future that is a forward expectation of a statistic that nobody can arbitrage.

And you've got a TON of people loading into this vechicle.

95% of $TVIX participants have NO CLUE as to what they're trading. They say "oh yeah this will make me money when the market tanks, it doesn't matter that the market has to trade like Sep-Oct 2011 for this to make sense"

Because of this demand, VelocityShares has stopped creating more shares.

Why?

Because this super high demand by retail guys who haven't the slightest clue as to how this works are breaking the VX futures market, keeping IV stupid high, and the roll yield may end up being prohibitively expensive.

This will end well.

Because of these volatility etfs, premium is staying higher than it should.

I'd even wager that it's causing a lack of steep correction in the market, and that the cost to insure a portfolio is still very elevated relative to how we are trading.

The Trades

The obvious trade to me is that April and May iron condors are a great trade here. IWO Premium put out a trade alert yesterday in our model portfolio.

But for the arb guys out there, check out the chart of $UVXY and $TVIX.

Same concept, different originator:

 

The multi-standard deviation move is related to the structural divergence, not fundamental. I expect these to re-converge, so a long $UVXY and short $TVIX pairs trade is a reasonable bet here.

 

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/