XIV is an ETF that inversely tracks the VIX.

To the uninitiated, the VIX is the so called ‘fear index’. It spikes like a motherfucker when the shit hits the fan, (see below) but most of the time ticks down.*


Today the VIX index ticked up by 3.86%. Now you would expect the XIV to tick down (note the inverse letters, very clever stuff) – but it went up by 4.16%.


To emphasise how odd this is by buying XIV (and I have, indeed, bought XIV) I am effectively short volatility and should only benefit when it goes down, but somehow it went up and XIV went up as well.

There’s a good reason for this.

The VIX is an index based on options.. it doesn’t actually exist, but you can calculate it. Not actually existing has never stopped anyone in finance from trading something, so all you need is someone to take the other side of the bet and off you go. There is a very developed market for VIX futures. (If the futures get out of whack with the options you could arbitrage the difference, and this keeps it in line.)

To create an ETF you need something behind it that covers the PnL. In this case, the ETF XIV owns the closest future, and each day sells a portion of it and buys the next month. So if it currently owns the April vix future, it will sell it down over the course of the month and buy the May future.

And this is the key to the riddle. Because lately the difference between the front future and the next in line has been ranging from +20-50%. So XIV gains 20-50% every month if all things stay the same.

It’s equivalent to selling 1/30th of your portfolio at 21 and buying it back at 14 every day each month.

The catch is obviously that this can reverse, and lose every month, which happened in August. But for now, I’m going to earn that yield, and fortunately, because this is an inverse ETF, you can only lose what you put in.

As I once got told by an otherwise incredibly dim-witted and dull person (who in any case was just repeating what someone told him), when vol is low you should be selling, and when vol is high you should be buying.

Vol is currently low, and I’m long XIV – so short volatility, but will earn the future spread – and will cream off the profits and save them for a rainy day.

Everyone follow that?

*As an aside one of my pet theories the fundamental market laws is that markets have a default mode and a panic mode… for example stocks can be relied upon to tick up no matter how high they have gone, but in panic mode they will crash down. Currencies are the same.. the aussie dollar can be expected to tick up, unless there’s a panic when it tends to crash. Sounds obvious but it goes against conventional market theory… it sure as hell isn’t symmetrical. Never fight the default mode.


Shale on.

The world’s best investment bank Squid just issued an excellent note on shale gas. I posted on this a while ago and the story is certainly filling out.

A few points stood out: 1. Natural gas prices, in both absolute term and relative to oil, have tanked. I often hear people assuming they will go up. If something drops dramatically, the first thing people seem to think is that it will go back up, and now it a buying opportunity. That is true if it’s a cyclical case. If it’s secular, i.e. driven by factors that aren’t cyclical, then there is no reason for something that has gone down, to go back up. Similarly, something that has gone up, won’t necessarily go back down if the story has changed. You probably won’t be able to buy Apple for $100 ever again, for example.


2. There are some big winners. US, Australia, China and Argentina stand out.


3. US energy imports are falling drastically as expected, but fortunately China is there to pick up the slack or prices would fall. Actually this is quite unfortunate as we all would benefit from lower energy prices, while only a handful of violent sexist extremist hoarders Western allies in the Middle East benefit when prices are high.


So how to play it? There are obviously some simple ways.. buying shale producers. But the easy money is certainly already made there.. not that you won’t still get decent returns on capital. The cost of sucking otu shale gas is so much cheaper than conventional drilling that the whole industry is likely to perform well.

My favourite pick? Buy US fertiliser producers. Natural gas is much lower in the US than elsewhere – one of the real anomalies in global finance right now. Natural gas is a key input, so US producers will have a huge advantage for a long time. And they are relatively cheap. Daniel Shand picked CF Industries, and I’m going to back him on this one.

Very volatile so a good candidate for selling puts, if current price seems a bit high.

Whilst on topic, has anyone noticed this? Doesn’t seem particularly bullish. Perhaps you could balance a long shale producers / short copper trade for a commodity neutral trade on this theme.