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I've recently written a couple of articles about the VIX Index and related ETFs. One of the key points I make in these articles is that there is a huge difference between the VIX Index and the VIX ETF. The tracking error is so poor that I make a warning at the beginning of the articles to ensure that readers understand that there are serious flaws in these VIX related ETFs. People interested in using the VIX related ETFs in their portfolios must understand how they perform and how they are constructed. These are very risky instruments, but can play a part in risk management if they are used properly.

Spoiler alert. In this article I detail a portfolio strategy based upon the VIX index. The "theory" portion discussion is based upon the actual VIX index. There are significant performance differences between the actual VIX Index and the ETFs that are based upon it. Significant adjustments must be made when implementing the "theory" to account for the reality that the VIX ETFs have significant tracking error. Theories based upon the VIX Index may not translate into real world portfolio management due to the lack of available securities that accurately reflect its behavior.

The main reason these VIX Index related ETFs perform so poorly is because of a condition called "contango." Contango is a situation when the futures price is above the cash price. What that means in practical terms is that if you buy a futures contract it will converge towards the cash price at expiration. The spread between the cash and futures price must be overcome before a profit can be made on the futures position. For example if the VIX Index is currently at 10, and the June future trading at 12, if the VIX index remains at 10 the futures contract will gradually lose value until it reaches 10 on the expiration date. Contango creates a situation where 3 out of 4 possible outcomes are losing trades. Using the above example of a future trading at a 20% premium, here are the possible outcomes.

1) The VIX Index remains at 10 until expiration: Result 20% Loss

2) The VIX Index falls below 10 at expiration: Result 20%(+) Loss

3) The VIX Index trades between 10 and 12 at expiration: Result 20%(-) Loss

4) The VIX Index trades above 12 at expiration: Result (+) gain.

Only 1 out of the 4 possible outcomes turns a profit. Those are not the kinds of odds that favor the investor, and why investors have to be very careful with these instruments.

When the odds are so skewed against the long position, the obvious solution would be to take the short side of the trade. That is a strategy I outlined in a previous article, but even that strategy has problems. Even with the odds favoring one side of the trade, because the VIX Index is so volatile, both the long and short VIX Index ETFs can go through extreme price swings.

Here's the background. The VXX has been a money furnace for five years. Launched shortly after the financial crisis as a means of owning volatility futures in an exchange-traded package, it has fallen an annualized 62% over five years. That's annualized, as in, falling an average of 62% a year.

In my opinion, there are three facts that must be understood about the VIX Index and futures to successfully integrate it into a portfolio management strategy.

1) The VIX Index usually finds a "home" or "base" level that represents a "normal" market environment. This "normal" level tends to change over time. Right not the "base" level appears to be between 10 and 12.

2) The VIX Index is a "fear" index, and because fear and panics are usually short-term in nature, the VIX Index tends to "spike" from its "base" level, and then return "home" as the fear subsides. This is not a "trending" index, it is more like an electrocardiogram or EKG, boomerang or homing pigeon.

3) The VIX ETFs use futures, they do not track the cash index very well. Because of this it is essential to understand the structure that exists in the futures market. As the article above highlights, the long VIX ETF has been a cash furnace since its inception.

The VIX Index futures have a couple of things working against them. The first is that the VIX Index is a "fear" gauge, so people buy it as "insurance" against volatility. Investors in the VIX ETFs understand the contango issue, but accept it because of how the VIX ETF is used. The VIX ETF is used like a put option, it is insurance. If a portfolio holds 10% in the VIX ETF as insurance and it loses 50% in a year, a 5% loss to the portfolio is most likely less than a put buying strategy would have been. Because of this, investors don't seem to mind bidding the futures up into a contango situation.

The other issue is that the VIX Index future isn't like a commodity future, there are no storage costs to be discounted, and the interest rate (carry cost) that is discounted in them is very low. The net effect of these factors usually lead to normal backwardation in the commodity futures market, but don't apply to the VIX Index futures.

Those factors tend to favor a contango market. Right now the $179.50 March Puts on the SPDR S&P 500 Index ETF (SPDR) cost about 1.4% and is 0.1% out of the money. The contango that exists between now and March expiration is 3.9%, so relative to a put strategy it is a bit expensive. Rolling the future forward is less expensive and only costs 2.65%. I would imagine/speculate that the 1.15% spread is largely due to speculators bidding up the VIX futures. Why buy a Bitcoin when you can make more on the VIX?

Going out 8 months, the monthly difference between futures' prices range between 1.62% and 3.72%, with the largest differences being in the near-term months. The difference between the cash VIX and the September VIX future is a whopping 21%. With that kind of premium built into the futures it is obviously why they burn through a lot of cash. Source of Following Graphic

(click to enlarge)

Understanding the contango metrics is essential to understanding the VIX ETFs, and how they will perform. With the near-term futures more sensitive to changes in the VIX Index than the long-term, buying the long VIX ETFs after the market has started to correct may be counter productive. As this graphic demonstrates, on February 3rd, the near-term futures traded above the long-term future. At the time the long-term futures were trading at a 24% premium. Clearly you want to buy the VIX ETF before such a premium develops in the futures.

(click to enlarge)

Obviously the strategy should be to buy the VIX ETF when all things look calm, as they looked on December 27, 2013 when they were making a 9 month low. This chart shows the difference between the December 27, 2013 low and the February 3, 2014 VIX peak. Clearly the time to buy the long VIX ETF is during the calm and not the storm.

(click to enlarge)

Because the premium built into the futures is so large, it is hard for the ETFs to overcome the spread, even with a 60% move in the VIX Index. This graphic demonstrates how a 60% move in the VIX only translated into a maximum 30% gain on the long VIX ETF (NYSEARCA:VXX). The other thing to note is how rapidly the trend reverses itself. The spike started about 2 weeks ago, and has already given back most of its gains. To effectively use the VIX ETFs, one has to have a market timing model that sells the VIX into strength or shortly after a peak so that it isn't given time to take back all the gains.

(click to enlarge)

In conclusion; the VIX Index, futures and ETFs are very complicated financial instruments. To effectively use them one has to thoroughly understand their dynamics and internal mechanics. The VIX is more a tactical tool than a strategic tool, and should only be used in buy and hold accounts with extreme caution and a complete understanding of how they fit within the portfolio as a whole. I would argue that even if there is a place for them in a strategic portfolio as a diversification asset in a buy and hold account, that some tactical strategy be developed to sell it into strength and lock in profits, instead of just providing a temporary hedge to smooth out portfolio returns during volatile times. If held long enough, it is almost certain that the long VIX funds will lose money as long as contango exists in the futures market. The short VIX funds are a different story, but they too can have extreme volatility and sizable draw-downs. In my opinion, it is best to use VIX ETFs in a tactical manner, buying and selling them, not buying and holding them. In order to do that one needs a model or discipline on which to base the trade decisions. Part of that model should be based upon the spreads that exist in the futures market and the whether or not a contango condition exists.

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Tracking Contango In The VIX Futures Market Is Essential To Effectively Using The VIX ETFs