Wednesday, May 6, 2015

SPY and VXX local dynamics: hedging with volatility products makes sense again

VXX is a one-month volatility ETF, sometimes used to hedge an exposure to S&P 500. Long term positions in VXX make no sense, because in average VXX is just a proxy to leveraged inverse fond to S&P 500 with leverage somewhere around 4. S&P 500 and VXX is highly correlated, when S&P 500 grows, VXX falls 4 times faster - simple. Here's VXX impressive downfall since its inception in 2009:

But if we normalize volatilities and make a pair chart for VXX+SPY equal-volatilities portfolio, we can see some interesting dinamics:

In 2009-2010 VXX was falling faster because of great volatility downfall after the crysis, but since 2011 you can see pretty obvious mean-reverting dinamics.

Last couple of months this pair went down because after elevated volatility of January when market calmed down it happened on practically stable S&P 500 levels, which is unusual, because most of the time when volatility falls, market grows.

If we assume, that volatility has already fallen enough, we can expect the normalized pair SPY+VXX will go up next several months, maybe up to a year, which makes market downturn hedging with volatility products not so bad idea.

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