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VIX Exchange Traded Products: Price Discovery, Hedging and Trading Strategy

Last Updated on 10 February, 2024 by Abrahamtolle

The financial landscape has witnessed a surge in volatility-related exchange-traded products (ETPs) in recent years, providing investors with opportunities to trade volatility without delving into options or futures. Among these, the VIX ETPs have garnered significant attention. The paper, “VIX Exchange Traded Products: Price Discovery, Hedging, and Trading Strategy,” by Christoffer Bordonado, Peter Molnár, and Sven R. Samdal, delves into the performance, price discovery, hedging ability, and trading strategies associated with the most traded VIX ETPs.

The VIX ETPs, tracking benchmark indices related to the S&P 500, offer investors avenues to engage with volatility without resorting to traditional derivatives.

The paper addresses the paradoxical nature of these products, characterized by negative expected returns due to time decay. Despite this, their popularity persists, warranting a closer examination of their dynamics.

The significance of this research lies in unraveling the performance, hedging capabilities, and trading strategies associated with VIX ETPs. The findings contribute to a nuanced understanding of these instruments and their role in investment portfolios.

This article provides an overview of the market, explores the significance of the research, discusses the methodology, and highlights key findings.

Methodology Used in The Research

The methodology employed in this research involves a meticulous analysis of VIX exchange-traded products (ETPs) with a focus on performance, price discovery, and trading strategies.

The study encompasses three main categories of VIX ETPs: direct (VXX and VIXY), leveraged (TVIX and UVXY), and inverse (XIV and SVXY). The authors utilize a robust dataset, employing 1-minute frequency data to capture granular market movements and facilitate a nuanced examination.

To investigate the efficiency of each ETP at absorbing new information, the authors delve into the concept of price discovery within each category.

Common factor weights, as introduced by Schwarz and Szakmary (1994), are utilized for this analysis. This approach allows for a quantitative assessment of the relative information impounding capabilities of each ETP, revealing lead-lag relationships and shedding light on the temporal dynamics of price movements.

Additionally, the paper explores the hedging effectiveness of VIX ETPs within a portfolio tracking the S&P 500. The study involves regression analyses, wherein the returns of various VIX ETPs are regressed against the returns of the S&P 500. The selection of the most suitable ETP for hedging purposes is based on estimated coefficients, with an emphasis on minimizing negative drag on the portfolio.

In the investigation of trading strategies, the authors propose a novel approach that involves buying both direct and inverse VIX ETPs and hedging the position with an S&P 500 ETF.

This strategy aims to exploit the time-decay inherent in VIX ETPs and strategically navigate the contango and backwardation patterns in the VIX futures term structure. The methodology incorporates considerations of transaction costs and emphasizes the practical implementation of the trading strategy in real-world scenarios.

Overall, the methodology adopted in this research combines quantitative analyses, regression models, and a nuanced understanding of market dynamics to unravel the complexities associated with VIX ETPs. By employing a multi-faceted approach, the study contributes valuable insights into the performance, price discovery, and trading strategies of these unique financial instruments.

Key Findings of the Study

The major findings of the study are as follows.

1. Performance and Price Discovery:

The research reveals intriguing dynamics in the performance and price discovery mechanisms of VIX exchange-traded products (ETPs). Within the direct and leveraged categories, it is observed that the more traded and older ETPs take on a leadership role in the price discovery process. Specifically, products like VXX and TVIX emerge as frontrunners in absorbing and reflecting new information.

Conversely, in the inverse category, a different pattern emerges, with the less traded and younger inverse ETP leading to price discovery. This nuanced insight into the lead-lag relationships within each category provides a deeper understanding of how different VIX ETPs assimilate market information.

2. Hedging Ability

Despite their negative correlation with the S&P 500, the research underscores the limited efficacy of VIX ETPs as hedging tools within portfolios tracking the S&P 500. While these instruments exhibit a negative correlation, suggesting a potential hedge against downturns in the equity market, the inclusion of VIX ETPs diminishes the risk-adjusted performance of the overall portfolio.

This counterintuitive result challenges the conventional wisdom regarding the hedging capabilities of VIX ETPs and prompts a reevaluation of their role in risk management within diversified investment portfolios.

3. Trading Strategy: Reaping the Market Fear

The paper introduces a trading strategy designed to capitalize on the unique features of VIX ETPs, particularly their time-decaying nature.

The strategy involves buying both direct and inverse VIX ETPs while simultaneously hedging the position with an S&P 500 ETF. In contrast to some existing findings, the research demonstrates that this trading strategy proves highly profitable.

By strategically navigating the contango and backwardation patterns in the VIX futures term structure, investors can harness substantial returns. This finding challenges conventional notions and opens avenues for investors seeking to leverage the inherent characteristics of VIX ETPs for profitable trading strategies.

Conclusion

In conclusion, the research sheds light on the multifaceted nature of VIX ETPs, revealing nuances in their performance, hedging capabilities, and trading strategies.

While these products exhibit negative expected returns and are unsuitable for buy-and-hold investments, the time-decay feature gives rise to profitable trading opportunities.

The findings underscore the importance of understanding the dynamics of VIX ETPs for investors looking to navigate the complexities of volatility trading.

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