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Creative Insurance Hedge


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The spread between 2012 March-April natgas could be a creative hedge for those of us who have large insurance exposures.  The spread is highly sensitive to supply availability, because of the high drop off in demand from for heating gas over that month.

 

This spread is trading very low right now relative to historical levels.  Supply disruptions due to events such as hurricanes would likely lead to gains here.

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The spread between 2012 March-April natgas could be a creative hedge for those of us who have large insurance exposures.  The spread is highly sensitive to supply availability, because of the high drop off in demand from for heating gas over that month.

 

This spread is trading very low right now relative to historical levels.  Supply disruptions due to events such as hurricanes would likely lead to gains here.

 

 

But hurricanes in the Gulf of Mexico don't blow then.

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I've got one that we are in with our discretionary cash that looks very interesting.  We are long the new XXV which is more or less the inverse of the VXX. The contango between the near month and next month for VIX futures is extreme, more than double the percentage that would normally be expected, so this should be a good trade unless something ugly happens.  We have hedged this trade to protect against a spike in volatility by buying S&P 500 puts as the implied vol on these is relatively low.  There is of course some basis risk in this hedge, but the trade nevertheless looks interesting with the big contango in the VIX futures combined with the relatively low implied vol in the puts.

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I've got one that we are in with our discretionary cash that looks very interesting.  We are long the new XXV which is more or less the inverse of the VXX. The contango between the near month and next month for VIX futures is extreme, perhaps double the percent that would normally be expected, so this should be a good trade unless something ugly happens.  We have hedged this trade to protect against a spike in volatility by buying S&P 500 puts because the implied vol on these is relatively low.  There is of course some basis risk in this hedge, but the trade nevertheless looks interesting with the big contango in the VIX futures combined with the relatively low implied vol in the puts.

 

How does this work?  I was scanning the prospectus here:

https://www.ipathetn.com/pdf/xxv-prospectus.pdf

 

and I couldn't find an explanation of how they are implementing this..  The last time I checked the VIX futures there was contango so that rolling from the front month to the back month cost quite a bit.  But how is the XXV implementing their strategy to inverse the vxx?  Do you know the details?

 

Thanks.

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I've got one that we are in with our discretionary cash that looks very interesting.  We are long the new XXV which is more or less the inverse of the VXX. The contango between the near month and next month for VIX futures is extreme, perhaps double the percent that would normally be expected, so this should be a good trade unless something ugly happens.  We have hedged this trade to protect against a spike in volatility by buying S&P 500 puts because the implied vol on these is relatively low.  There is of course some basis risk in this hedge, but the trade nevertheless looks interesting with the big contango in the VIX futures combined with the relatively low implied vol in the puts.

 

How does this work?  I was scanning the prospectus here:

https://www.ipathetn.com/pdf/xxv-prospectus.pdf

 

and I couldn't find an explanation of how they are implementing this..  The last time I checked the VIX futures there was contango so that rolling from the front month to the back month cost quite a bit.  But how is the XXV implementing their strategy to inverse the vxx?  Do you know the details?

 

Thanks.

 

 

Barclays doesn't give details.  Just a general reference to hedging in their prospectus.  The simple way to do this would be to short the VXX.

 

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The spread between 2012 March-April natgas could be a creative hedge for those of us who have large insurance exposures.  The spread is highly sensitive to supply availability, because of the high drop off in demand from for heating gas over that month.

 

This spread is trading very low right now relative to historical levels.  Supply disruptions due to events such as hurricanes would likely lead to gains here.

 

 

But hurricanes in the Gulf of Mexico don't blow then.

 

And corn isn't harvested in the spring, but weather in the spring can affect its harvest prices.

 

Hurricanes typically threaten supply right before peak heating season (fall).  This can cause the march-april spread to widen.

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I've got one that we are in with our discretionary cash that looks very interesting.  We are long the new XXV which is more or less the inverse of the VXX. The contango between the near month and next month for VIX futures is extreme, more than double the percentage that would normally be expected, so this should be a good trade unless something ugly happens.  We have hedged this trade to protect against a spike in volatility by buying S&P 500 puts as the implied vol on these is relatively low.  There is of course some basis risk in this hedge, but the trade nevertheless looks interesting with the big contango in the VIX futures combined with the relatively low implied vol in the puts.

 

I've been short the VXX since about 29, after the flash crash.  Its at 15 now.

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I've got one that we are in with our discretionary cash that looks very interesting.  We are long the new XXV which is more or less the inverse of the VXX. The contango between the near month and next month for VIX futures is extreme, more than double the percentage that would normally be expected, so this should be a good trade unless something ugly happens.  We have hedged this trade to protect against a spike in volatility by buying S&P 500 puts as the implied vol on these is relatively low.  There is of course some basis risk in this hedge, but the trade nevertheless looks interesting with the big contango in the VIX futures combined with the relatively low implied vol in the puts.

 

I've been short the VXX since about 29, after the flash crash.  Its at 15 now.

 

 

Good show!   Shorting the VXX or buying the XXV is a good bet.  Combining one of these operations with buying a cheap OTM S&P put gives up a small part of the upside, but provides insurance against extreme tail risk, giving us confidence  to take a position many times larger than we would otherwise be comfortable with.  This index will lose value at a much higher rate than other indexes during a market sell off. and the hedge lets us sleep well with a fairly large position.  The position currently amounts to most of our discretionary cash that has been growing as we have sold almost all of BRE, as it approaches its take out price.  :)

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XXV has kind of bugged me, because it doesn't seem to track VXX the way I expected it to.  So I looked into it, and these are my tentative conclusions excerpted from a recent email I sent.  I'm about 80% confident of the conclusions now, and will be 99% confident with another 6 months of data.

 

The thing that's confusing is that it literally is as if you shorted VXX.  This has a bunch of really odd implications.

 

1.  If XXV was sold at an initial price of $20 when VXX was at about $25.  If VXX goes to 0, XXV will go to 40.  XXV can never go above 40.  (Because when short a stock, you can never make more than a 100% return.)

 

2.  The percentage changes of VXX and XVV are not inverse.  e.g. If VXX goes from 2 to 1, that's a 50% decline.  That doesn't imply a 50% increase in XXV.  In fact, the return will only be something like 4%, since VXX will have already moved down so much that a huge percentage move in VXX will have almost no effect in XXV.  It's the absolute magnitude of the move that matters, not the percentage, and a $1 move on a stock that you shorted at $25 isn't that big.

 

3.  You can see the declining effects of VXX moves on XVV by looking at relative changes since XXV was formed.  The constant used to be around -0.75.  Now it's -0.5 or less.  (i.e. if VXX moves 1%, XXV will move less than -0.5%).

 

4.  XXV was way more attractive initially (but there was also a greater risk of liquidation if volatility rose and XXV went below $10 and was instantly liquidated for a 50% loss (a neat detail in the prospectus)).

 

5.  If XXV ever gets options, short as many $42.50 calls as you can, since the stock can never get there.  :)  I think.

 

6.  XXV is largely useless now.  Maybe you can get a 20% return in the next year if it hits $35, but you're taking volatility risk to get it.  It might become interesting again if volatility spikes/backwardization in VIX futures appears and XXV falls below $25.  Of course, then you have to worry about the $10 floor.

 

Richard

 

Disclosure: Short VXX

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XXV has kind of bugged me, because it doesn't seem to track VXX the way I expected it to.  So I looked into it, and these are my tentative conclusions excerpted from a recent email I sent.  I'm about 80% confident of the conclusions now, and will be 99% confident with another 6 months of data.

 

The thing that's confusing is that it literally is as if you shorted VXX.  This has a bunch of really odd implications.

 

1.  If XXV was sold at an initial price of $20 when VXX was at about $25.  If VXX goes to 0, XXV will go to 40.  XXV can never go above 40.  (Because when short a stock, you can never make more than a 100% return.)

 

2.   The percentage changes of VXX and XVV are not inverse.  e.g. If VXX goes from 2 to 1, that's a 50% decline.  That doesn't imply a 50% increase in XXV.  In fact, the return will only be something like 4%, since VXX will have already moved down so much that a huge percentage move in VXX will have almost no effect in XXV.  It's the absolute magnitude of the move that matters, not the percentage, and a $1 move on a stock that you shorted at $25 isn't that big.

 

3.  You can see the declining effects of VXX moves on XVV by looking at relative changes since XXV was formed.  The constant used to be around -0.75.  Now it's -0.5 or less.  (i.e. if VXX moves 1%, XXV will move less than -0.5%).

 

4.  XXV was way more attractive initially (but there was also a greater risk of liquidation if volatility rose and XXV went below $10 and was instantly liquidated for a 50% loss (a neat detail in the prospectus)).

 

5.  If XXV ever gets options, short as many $42.50 calls as you can, since the stock can never get there.  :)  I think.

 

6.  XXV is largely useless now.  Maybe you can get a 20% return in the next year if it hits $35, but you're taking volatility risk to get it.  It might become interesting again if volatility spikes/backwardization in VIX futures appears and XXV falls below $25.  Of course, then you have to worry about the $10 floor.

 

Richard

 

Disclosure: Short VXX

 

 

You're mostly spot on with your take on XXV.  It is a strange beast, isn't it?

 

Re your point #1: I think the max upside for XXV is about $45, plus the accumulated gain in the imputed T Bill derrivative that's imbedded in the XXV, rather than $40 because VXX was about $25 when XXV was launched.  This is one of the many confusing things about this animal because XXV was priced at $20 at launch.

 

XXV does have some advantages that may not seem important now, but could be later.  A buyer gets the T bill rate on the money invested in addition to any inverse performance of the VXX.  Interestingly, A buyer of the XXV when it debuted at $20 would get double the T Bill interest, adjusted for any change in the interest rate, that was paid on his original investment as the price of the  XXV rises above $40.  :) This is something that a VXX sucker, oops excuse me, I mean investor, doesn't get, according to their doccuments.

 

The thing I like most about XXV is that it has a built in stop loss feature that would be triggered if the intraday price of XXV touched $10.  I like this because it's a big distraction for me to get in a day trading mode and have to constantly monitor a short position that could keep getting uglier and uglier.  If we are dilligent to maintain our hedge of OTM S&P500 puts, we should be protected on the downside and be able to go to sleep on this one, even if our position is much bigger than a normal limit for a short in the VXX would be.

 

The wierdest thing about the XXV is the increasingly negative leverage that occurs as the price of the VXX declines, and decline it must over time.  As the price of the XXV rises, the percentage gain from a corresponding percentage decline of the VXX becomes less, although the one for one, dollar for dollar, corresponding rise and fall should be about the same.  The capital efficiency aspect will become increasingly poor approaching the limits of zero for the VXX and about $45 for the XXV.  Mitigating this is the comfort that the investor will continue to accumulate interest at the T Bill rate.  

 

This is not an attractive long term investment unless someone likes owning T Bills with an element of risk thrown in as the XXV nears its limit.  It's right for us now, but it will become increasingly unattractive as time passes and the price likely increases.  For most active trading pros, shorting the VXX makes more sense.  :)

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FYI We closed out our XXV trade today for no earthshaking reason, just a combination of little things.  Our Puts to hedge the position expire tomorrow and the Nov and Dec puts are more pricey; there could be more volatility as the election nears, etc.  Bought some more of two of my favorite Bermuda insurers this week. We'll sit on the small amount of remaining cash for a while and see if anything else interesting turns up.

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