This is a follow up to a post from the always excellent Trading the Odds showing that XIV (inverse VIX) is particularly strong (and VXX particularly weak) in the two days prior to VIX futures expiration, as futures are usually forced to converge down to the spot VIX as a result of VRP. I’ve shown TTO’s results to the right (click to zoom).
I have a slightly different take on the subject. XIV strength on those days isn’t, in and of itself, necessarily an important bit of data. Given the fact that we have limited VIX ETP history to consider (just over 10 years), it could be that, just by happenstance, equities were strong on those particular days and XIV was merely along for the ride.
A different approach would be to look at the daily excess return of XIV, above and beyond what we would expect given the day’s change in equities.
In the graph above I’ve shown just that: the daily excess return in XIV by days to expiration.
I performed a simple linear regression between all available SPY (cash only) and XIV data, and calculated XIV’s average daily return in excess of that regression, for each day. The relationship between daily changes in SPY and XIV is not linear, but close enough for the purposes of this illustration.
Note the jump in excess return 1 and 2 days prior to expiration, confirming TTO’s original observation. To clarify, that doesn’t necessarily mean that those days were positive (or for example, that day 4 was negative), only that they tended to return more or less than one would expect given the day’s change in equities.
Just for fun, the following graph shows two hypothetical portfolios. The first (blue) only buys XIV 1 and 2 days prior to expiration, and the second (grey) buys XIV on all other days. All trades are close-to-close, and I’ve ignored transaction costs and slippage.
The graphs shows that, to date, it’s been mostly smooth sailing for XIV 1 and 2 days before expiration. But, likely by pure happenstance, it’s also been smooth sailing for SPY on those days as well (not shown for the sake of brevity). So that means that those positive XIV returns in TTO’s data are partially a result of the excess return on those days that we’ve shown here, but it’s also likely partially because nothing particularly bad has happened to equities on those days either.
Wonk note: The observation discussed in this post is much less pronounced with ZIV/VXZ (mid-term VIX ETPs) because they’re based on futures that are further from expiration and thus are not forced to converge to the spot VIX while ZIV/VXZ holds them.
Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.
Volatility Made Simple