Why XIV gave 181% returns in 2012.

Looking at the yearly performance of ETFs ,we can see that some of these ETFs significantly outperformed their counterparts. 

Out of these names, the first name is of significant interest here.

Why XIV was the best performer in Year 2012

The main reason for this absolute out-performance  is because of the way these volatility ETFs are structured. 

VXX - This Etf is based on constant weighted average of VIX futures maturity of 1 month

VXZ - This Etf is based on constant weighted average of VIX futures maturity of  5 months.

Details at the following site.

http://www.ipathetn.com/static/pdf/vix-prospectus.pdf

So what exactly are VIX and VIX futures?  CBOE's education site describes it as follows:

"The CBOE Volatility Index is based on real-time prices of options on the S&P 500 Index, listed on the Chicago Board Options Exchange (Symbol: SPX), and is designed to reflect investors' consensus view of future (30-day) expected stock market volatility... The contract multiplier for each VIX futures contract is $1000."

Since VIX is just a computed number, the way to trade VIX is using VIX futures or options on VIX.  The prices of VIX futures are dictated by actual market price. The VIX options are based on the VIX future prices.

If look at a chart of the VIX, you will see that it remains in downtrend for quite a bit of time and then it just runs upwards crazy in exponential fashion and then again come crashing down

There are couple things once can  one can observe on the VIX  and VIX futures charts.

• The prices of VIX futures in different month are different 
• There are short term momentum spikes in VIX and near term VIX futures
• Effect of SP-500 options trading.

The different prices of VIX futures are also called Forward Curve or Term Structure. Term Structure or The forward curve is a graphical representation of the current price of each futures contract over a period of time.

Here is the latest scenario of VIX term structure. 

From the above picture you can see the various months VIX futures. The same information is also available on www.cfe.cboe.com. The futures months are prices upwards towards the mean value of VIX. This upwards slope is called Contango  in Options world.

 If the price of VIX does not change then at settlement the futures contract will have to come down to price of VIX which is also called SPOT price. Hence the difference between the forward price of VIX futures and VIX will be lost.

For e.g Currently March VIX future contract is at 18.05 and VIX is today 14.68. So the difference is 3.37 points Now since VIX futures are mutliples of 1000, So the amount lost will be $3337. 

So as long as the VIX futures keep on sloping upwards, the difference between high VIX futures prices and VIX will be lost.  Hence the ETFs like VXX or VXZ are at significant disadvantage. 

So if there is no movement in VIX or if VIX remains range bound then these ETFs based on VIX futures will continue to perform badly. 

Now there are two ways to capture this type of melting effect, You can short VXX or VXZ etf or you can buy XIV and keep trailing with a stop loss of 75 cents to $1. 

The only caution area here is the deterioration of Term Structure or VIX running up exponentially.