USE OF THE IPATH S & P 500 VIX SHORT-TERM FUTURES ETN AS A NON-CORRELATED ASSET & HEDGE

I have just been contemplating the potential use of the new ETN for the VIX short term futures as a non-correlated asset in my asset allocation.  I have made the following observations about this new security. 

I would expect any security attempting to match the VIX to be negatively correlated with the S & P 500 index.   Generally, I would expect the VIX to move in the opposite direction of the S & P 500.  On days when the S & P 500 moves up or down by over 1%, I would expect the VIX to move in a greater percentage in the opposite direction. 

In my asset allocation, I have no interest in trying to play short term moves in  major asset classes such as stocks or bonds, by shifting significant sums back and forth for short periods, though I will sometimes try to manage the risk of a position using shorter terms moves in the volatility patterns of a particular security. 

My interest in this new ETN, VXX, would be as a hedge for my stock portfolio, as a non-correlated asset, or as part of what I have called in these posts a Swing Trade.Trading and Asset Allocation in Stable and Unstable VIX Pattern BEEPRA VIX LXPPRD/ More on VIX AND ASSET ALLOCATION  My initial opinion is that I would prefer using a more highly negatively correlated security such as the double short ETF for the S & P 500-SDS.

When deciding whether a security has a place in my asset allocation as a non-correlated asset, the first determination that needs to be made is the strength of the non-correlation.  The VXX would be a strong negative correlation with the S & P 500.  ETN   That link is to the web site for the sponsor of this ETN.  The sponsor claims a negative correlation of -.74 with the  S & P.  I have no training whatsoever in statistics, but I understand that -.74 is a very high negative correlation, which is measured on a zero to -1 scale.

Since this product is tied to VIX futures  it does not have a 1 positive correlation to the VIX, and that positive correlation is currently listed by the sponsor as +.71.  There is a 1 correlation to the S & P 500 Vix Short Term Futures Index.  

Since this product was launched the VIX has been falling, so I would expect VXX to be going down significantly, which is in fact the case. 

The second issue for me is whether I have a strong opinion on whether or not the negatively correlated asset will rise or fall.  I do not currently have such an opinion on VXX because I have no opinion on either the short or medium term movement of the VIX.  For obvious reasons, I do not want to use a non-correlated asset when I have a strong opinion that it will fall in value.

I would not use VXX as a negatively correlated asset during a Stable VIX Pattern. Vix Asset Allocation Model Explained Simply With as Few Words as Possible  In that bull market pattern for the VIX, I would now have a strong opinion that ownership of  VXX would most likely be a drag and would serve no useful purpose in my asset allocation.  

Once the Stable Vix Pattern is broken by a Trigger Event, such as the one which occurred in August 2007, then I could see in the future using VXX as part of an uncorrelated asset class and as a hedge.   One possible use would be in an analogous trade to the SSO/SDS Swing Trade described in several prior posts.  In 2007, once the Unstable Vix Pattern formed in August 2007, then I would wait for a swing back to 20 or below in the VIX, and then I would consider adding VXX. VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern Then, since a characteristic of the Phase 1 Unstable VIX  Pattern is a Whipsaw Pattern moving from 20 to 30, I would sell some or all of VXX when the VIX spiked to or over 30. This would have happened soon after its purchase in early October  2007 with a sell in November and so on. 

If it looked like a Phase 2 Unstable Vix Pattern was going to form, similar to what happened in September 2008SEPTEMBER 2008: FORMATION OF THE DEADLY PHASE 2 OF THE UNSTABLE VIX PATTERN,  then I could buy the VXX as a hedge and a non-correlated asset at least until volatility simmered down. 

At most, I would consider using VXX in the future as primarily a hedge in an Unstable VIX Pattern, probably as a small and integral part of a Swing Trade utilizing primarily SDS and TWM in the first year of a  Phase 1 Unstable Vix Pattern.  I might incorporate VXX into that kind of trading model, where I would keep it longer on a spike in the VIX than I would SDS for example (by way of an illustration only, I could sell SDS on a spike in the VIX to 28 to 30, but keep VXX until a 33 to 35 range in the VIX.)   I would also possibly keep a very small number of shares of VXX in reserve as a hedge until such time as a Stable Vix Pattern emerges, meaning 3 months of continuous movement below 20.  So I view VXX now as more of a potential hedge in a volatile Unstable Phase 1 Vix Pattern, and part of a Swing Trade, rather than as an asset that would be held simply because it was a non-correlated asset.  In effect, I see this security being integrated into a new Swing Trade model to be refined later for use in the next bear market.

 I would be very reluctant to use VXX coming out of a Unstable VIX Pattern where the movement suggests the VIX may possibly be heading to the formation, over the course of several months, a Stable Vix Pattern.  I would be more willing to utilize it as part of a Swing Trade after the occurrence of a Trigger Event after a long term Stable Vix Pattern.   I will consider using it now only in very small amounts, possibly buying some on a move down into the low 20s and taking it back off entirely on a move to close to 30, and then completely eliminating it altogether once some continuous movement is established below 20.  Most likely, I will not buy VXX prior to the breakdown of the next Stable VIX Pattern.  A better non-correlated hedge for the S & P 500 would be the short or double short ETFs.  ProShares ETFs – Funds - Overview (Hubpage) – – Overview This post from SeekingAlpha contains positive correlation statistics between the VIX and several ETFs such as SDS in excess of .5.  Seeking Alpha 

ETNs have some unique issues that are beyond the scope of this post, including some tax related issues. http://www.ipathetn.com/pdf/vix-prospectus.pdf

I do not currently have a position in VXX, SDS or TWM, and I am hesitant to use any of them 16 months into a bear market.  I would prefer focusing on using those securities in the first 16 months of an Unstable VIX Pattern, such as the 16 months starting in August 2007.  I am admittedly a conservative investor, and very, very distant from a wild and crazy guy.   

For most of this week, I will probably be discussing non-correlated assets as part of my Dynamic Asset Allocation approach. Time for a Paradigm Shift in Asset Allocation Theory: Need Dynamism, Better Assessment of All Forms of Risk, and Due Regard to Volatility PatternsStatic v. Dynamic Asset Allocation

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