Long Versus Short
It may seem obvious that the best way to make money from volatility is to buy in (or go “long”) in order to participate in these huge spikes when they occur. This is an approach used by many individual and institutional investors. But there is one big problem: The derivatives that are correlated (meaning they move in the same direction as the VIX) have to get this exposure from somewhere. In order to be exposed to the upside, someone else has to be exposed to the downside or “short”. The short investor isn’t going to give the long investor this exposure. They are going to demand a payment to take the risk of delivering the positive movement of the elevated VIX at some point in the future. The other problem is that these products can’t be built to match the movement of the VIX over a month or a year, since the movement happens so quickly. Instead, they are built to attempt to mimic the movement over a day. When you compound volatility, a bad thing happens. Start at 100 and add 10%, then subtract 10% and repeat, and you’re on a path to zero. As you can see in the chart, after just 30 days, this compounding volatility drive 100 down below 80.
Take a look at the longer term results of the long VIX etf (symbol UVXY*) when overlaid on our previous chart.
Source: Yahoo Finance VIX vs S&P 500 vs UVXY
That green line represents the long VIX investment over two years. And yes, that is nearly a 100% loss. Although there were significant positive gains early on, the compounding effect of volatility simply destroys this ETFs value over time. The primary way to profit from this vehicle is to anticipate a spike and make a purchase just before it happens and then sell at or near the top of the spike and get out. And repeat that successfully time after time. In our opinion, not very predictable or dependable strategy.
Let’s instead look at the short VIX derivative that we use in our MVP strategy: SVXY*. This ETF has some of the same compounding problems that UVXY has, but it benefits from the receipt of premium from the investors who want to own positive volatility. Over the same time period here are the results of the short VIX ETF
Source: Yahoo Finance VIX vs S&P 500 vs UVXY vs SVXY
Rather than suffering along the way, the short VIX derivative actually compounds in a positive manner because of the significant premium it receives for taking the short side of the volatility trade.
*IMPORTANT NOTE: The information presented here is intended for informational use only and does not constitute specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, please consult your financial advisor prior to making any investment. The financial instruments discussed herein are extremely volatile and in certain circumstances could result in a total loss of your investment in a single day. Only professional investors with significant experience should consider using these instruments.