Regarding XIV and VXX, what's the model for trading them in combination? How do they work?
I don’t consider myself any sort of expert on the matter I’m afraid but these instruments are simply opposite sides of the same coin. It’s all about options and futures. These derivatives are not just for speculators: some fund managers buy volatility as a hedge against a long portfolio of S&P Equities. Volatility has tended to rise during market crashes and hence has provided a balance to falling equity values.
So as a holder of XIV I am effectively selling insurance to fund managers for a premium. The premium can be seen in the contango between (by way of example) the front month futures contract and the spot VIX. The premium will go down as contract expiry approaches in the same way that an options value decreases over time. Most of the time. And at expiry, the option writer can sell a new call on vol for a further premium and the seller of futures can sell the new contract for his return – contango, the positive difference between the front month price and spot VIX.
So it works like any other insurance product: the insurer collects premiums and profits when (and only when) the policy holder makes no claim. The market is in contango 75 to 80% of the time and volatility tends to move sideways (not sharply up). So for most of that time a seller of volatility (insurance) collects the premium and profits. XIV is selling premium and therefore goes up in time unless there is a calamity when it will get wiped out. Just as any insurer can get wiped out if he has overplayed his hand and not re-insured any of the risk.
The object of these systems is to collect that insurance premium while it is there and to exit the market when it is not. As a bonus, if you can get the timing right, when contango disappears in a mega crisis you reverse the trade instead of going flat. You buy volatility: go long futures, buy a call, buy VXX the inverse of XIV.
The existence of contango or its opposite (backwardation) seems to be a good trigger, a good indicator. And that makes fundamental business sense: it’s a business: sell insurance for a premium when you can. Pack up business or do the reverse trade when there is no contango or when contango does not cover the risk of rising volatility.
Its difficult to get the concept of contango and backwardation without looking at the charts of simultaneously trading futures contracts with different expiry dates. And also you should build concatenated time series simulating being long and short of these contracts. That way you get to see exactly how this premium works.
I wish I could post examples here – it’s a lot easier to describe all this with pictures and figures. But there you go!
The reason I like this trade is not that I believe it will necessarily last forever but that at the moment it makes genuine commercial sense. You are selling insurance and like any insurer you are relying on statistics to try to provide that the premiums you collect will, over time, cover not only the occasional claims on the policy but also give a profit margin.
This is exactly the sort of trade despised by Naseem Taleb who (probably rightly) says that the Black Swan will eventually wipe you out if you are too aggressive. These sort of trades have been aptly described as picking up dimes in front of a freight train.
So you need to hedge or re-insure in some way. Not perhaps as difficult as it may seem: rebalance, don’t overtrade, use hopefully reliable indicators. Hopefully a combination of these provisions should / could keep you in the game.