A few notes on XIV VXX pair trades
Every so often I come across a post or comment on some kind of XIV/VXX pair trade. I wrote one such post in 2011 toward the beginning of my volatility research. I thought I’d write another post now to shed more light on some of the ideas that get thrown around.
I’ll examine 3 types of trades here:
- Long XIV and long VXX
- Short XIV and short VXX
- Long XIV and short VXX
For each type of trade I’ll examine a 50/50 allocation (e.g. 50% short XIV/ 50% short VXX) and examine all the past outcomes of holding this trade 60, 90, and 120 days out. I’ll leave it to readers to try other combinations of weights, time lengths, and any fancy embelishments.
Note: Values before product inception are simulated based on the VIX futures .
Long XIV Long VXX
This pair goes long both products. The hope is that one of these breaks out and rises significantly from the purchase price. As an example, assume XIV rises around 100% over an extended period and VXX falls around 50% over that same period. In this case, the pair trade would be up 25%. If the returns are flipped around, the pair would still be up 25%.
This chart shows the return profile of purchasing the pair on the specified date and selling 60, 90, and 120 days later.
I was surprised by a couple findings while doing this analysis. I’m sure others have thought of them but they are new to me. These findings include:
- This pair only does well when a long XIV position outperforms a short VXX position over the specified period. In a sense, this pair is betting on that to happen.
- The returns of this pair are slightly negatively correlated to equities and nearly uncorrelated to government bonds. This presents promise as a portfolio diversifier.
Of the three pairs, I like this one best. Negative returns are subdued while positive returns can be quite high. It’s also the easiest trade to execute consistently as you don’t have to worry about finding shares to short.
Short XIV Short VXX
This pair is short both products. The trade is profitable when neither product rises that much from the purchase date. The return profile is inverse to the long/long pair. This pair only does well when a short VXX position outperforms a long XIV position over a specified period.
Below is a chart of returns for this pair. Because of the nature of short positions, it’s possible to lose more than 100% on a trade. Upside returns are also limited due to the decreasing leverage a short position provides as a shorted product declines in value.
I don’t like this pair very much. It can be profitable but really requires a lot more active management to avoid the issues of varying leverage shown in the chart.
Long XIV Short VXX
This pair is not neutral like the other two. You’re basically shorting volatility in two different ways. This means you better have a system for entering/exiting the trade. When the trade is working well it will outperform the other pairs given its directional bias.
Here is a chart showing past returns for the pair.
The short part of the trade presents the same leverage issues as the short/short pair shown previously. I personally prefer using a simple long XIV position for shorting volatility.
Pair returns compared to equities and bonds
I mentioned earlier that the long/long pair had slightly negative correlation to equities and near zero correlation to bonds. Here I’ve posted a chart comparing the long/long pair to returns of SPY and IEF over 120 day holding periods. There appears to be some nice diversification going on.