Here’s what happens to SVOL under different scenarios, including worst-case scenarios

Simplified Volatility Premium ETF (NYSE:SVOL) is one of my favorite ETFs and I’ve written about it in several articles in the past.

SVOL can be a good addition to your income mix

SVOL: Still strong despite gains volatility

One question I often get about SVOL is what would happen to the fund under different scenarios, including a black swan event like we saw in 2018 or 2020. Many people are familiar with the “Volmageddon” incident in 2018, when the VIX suddenly climbed from 10 to nearly 40, which had a serious impact on several funds that were short the VIX at the time. Some prominent funds like XIV collapsed completely and dropped to zero, leaving investors with nothing.

So it’s fair to have investors begrudgingly wonder what will happen to SVOL. events like this. In this article, we will try to calculate the impact of different scenarios on SVOL.

To better understand the impact of different VIX levels on SVOL, we have to take a deeper look at the fund’s current holdings (which are subject to change without notice since the fund is actively managed). We’re only interested in the holdings highlighted in yellow, as these are the “active ingredients” of the fund, while everything else is bonds, cash, and bond funds that SVOL uses as collateral. These increase the fund’s total return by approximately 5% but do not affect the results of its VIX investments.

As you can see, the fund is short VIX futures expiring in January 2024 and March 2024, and long VIX 50 calls expiring in December 2023. Another thing worth noting is that the fund only uses about 22% of its assets to short VIX futures so it’s not fully exposed. Technically, for every 10% increase in the VIX, this fund could theoretically only lose about 2.2% of its value, but it’s not that simple, as we’ll show below. Additionally, we could have an event like 2020, where the VIX rose 500% in 3 weeks. What then? Does this mean this foundation explodes?

Currently, at the time of writing, the VIX index is at 13. What would happen if the VIX suddenly jumped to 20 overnight? We expect the value of the January 2024 VIX futures contract to climb from $17.96 to $24.96, the March contract value to climb from $18.84 to $25.84, and the VIX 50 option value to climb from 29 cents to 45 cents. As a result, SVOL will lose approximately $33 million from its futures contracts but gain $12 million from its VIX options, for a total net loss of $22 million. This would result in a 6% drop in SVOL’s NAV, which isn’t bad considering the VIX almost doubled overnight in this scenario.

What does the VIX climb to 30 overnight mean? Now, our VIX futures are getting a higher value, but the same value as the VIX options held by the fund. All told, we saw the fund lose about $59 million, or 15%, of its NAV. That may sound scary, but the VIX rarely jumps from 13 to 30 overnight, and the fund seems far from being blown away like the XIV was in 2018.

Now let’s relive the “Volmageddon” event of 2018, where the VIX suddenly jumped to 40 overnight. Note that the fund’s short futures contracts are getting a lot of value, but so are the VIX options it’s buying as a hedge. This is because in the event that the VIX jumped from 13 to 40, the value of the VIX 50 option would also jump from 29 cents to $2.05 because the IV of the VIX itself would also rise significantly (yes, even VIX options have their own IV ). The situation softened considerably, with the fund losing only 18% of its NAV. So the difference between the VIX jumping to 30 or 40 would only have an impact of 3% on SVOL’s NAV, which is impressive. But what is certain is that in this case the fund will not explode or even close.

What happens if the VIX quickly jumps to 80 like it did in March 2020? You will be surprised. Not only did SVOL not explode, it actually became positive because it had all those VIX 50 calls. The fund lost $330 million from the futures contract but gained a whopping $934 million from the VIX calls, implying a gain of $604 million, or 150%. Unbelievable right?

In fact, the fund loses value until the VIX rises to 50, but then the fund actually starts making money because of how many VIX contracts it holds as a hedge.

Having said that, it is extremely rare for the VIX to break above 50. It has only happened once in the past 14 years, and that was the complete shutdown of the global economy in March 2020. This was a complete black swan event. My point is that this fund is specifically designed to ensure that it doesn’t crash like a few funds like XIV in 2018.

The fund could still lose value, as it did last year when the VIX climbed into the 30s. Just because a fund won’t collapse doesn’t mean it won’t lose value. Also keep in mind that this is an actively managed fund, so the fund managers can change their holdings at any time, and they may get greedy and make a mistake or two when removing or reducing hedges, leaving the fund exposed to greater Loss. Just because the fund is currently set up to avoid today’s plunge, doesn’t mean it will be the same in the future.

Also note that the fund’s futures contracts are dated January and March 2024, while its VIX 50 call options are dated December 2023. This calculation assumes that a VIX burst event will occur before SVOL’s VIX call options expire, or that SVOL will continue to roll over its VIX call options (as it has been doing). If the fund somehow “forgot” to hedge and the VIX fell significantly, SVOL could lose significant value. I’ve never seen this fund unhedged, so that makes me feel better.

The fund, which is only a few years old, has posted a total return of 27% since inception, far exceeding the S&P 500 Index’s (SPY) total return of 13%. One can only hope that the fund can continue this outperformance in the future.

All in all, I think this is still a good source of income. No investment is risk-free, and this one could lose value over time, but I think if management remains disciplined, it has a better chance of continuing to outperform. We’ve seen too many great funds go bankrupt in the past because management got greedy and relaxed their hedging, but I’m optimistic this won’t be one of them.