In the first half of 2011, I wrote several times about the short VXX trade as a way to profit from the consistent contango that existed in the volatility futures market. The contango trade took an extended summer vacation as the volatility spike in August caused the volatility futures curve to shift into backwardation.
As we open the book on 2012, it looks as though old patterns are beginning to resurface.
Impact of Contango on Volatility Funds
For those not familiar with contango and how that impacts volatility funds like VXX and XIV, a quick primer:
VXX is an iPath ETN designed to mimic a 30 day futures contract on the VIX spot index (note: the VIX “spot” index is not directly tradable, so short term futures are the nearest proxy). The fund managers accomplish this by maintaining a balance of front-month (the next futures expiry date) and second-month contracts that keep the VXX always about 30 days out on the curve. As an example, on T=1, the first day after contract expiry (e.g., May 18th), the VXX “holds” only contracts for the next expiry (June contracts). By T=15, the VXX consists of 50% June contracts and 50% July contracts, thus maintaining the 30 days away from expiry structure. Therefore, each day the VXX “sells” 1/30th of its assets in front month contracts and rolls them into second month contracts.
When the VIX futures curve is upward sloping, meaning people expect volatility to be greater in 2 months than in 1 month and so forth, there’s an ongoing premium that must be paid to continually sell front month contracts and replace them with second month contracts (which, themselves become front month contracts in a few weeks’ time). This situation of more distant futures costing more than near-term ones is referred to as contango and the buy-high-sell-low situation it creates is called roll yield, or more specifically, roll cost.
Contango creates a “headwind” to longs of ETNs like VXX, but a tailwind for shorts. Conversely, backwardation creates a tailwind to longs, and headwind to shorts. Thus, a straightforward strategy is to be long volatility ETNs when markets are in backwardation and be short when in contango.
The below chart illustrates how this strategy has played out over the past 24 months. The top pane of the chart shows roll yield calculated as [front-month-future]/[next-month-future]- 1, where a positive value indicates backwardation, negative represents contango. For clarity, periods of backwardation are highlighted in light red. Daily returns on the above-described strategy are indicated by the red-green bars in the middle pane. At the bottom are the daily price bars for VXX, the iPath S&P 500 VIX Short Term Futures ETN.
Click to enlarge
Current State of the VIX Futures Curve (as of January 3rd)
The futures curve appears to be in a fairly normal contango, upward sloping for each of the next 7 months.
Volatility Futures Curve as of Jan 3, 2012 close
List of Volatility ETF / ETNs
Volatility ETFs have rapidly come to market in the past few years, so there are now many ways to play this trend. The largest and most liquid option is the VXX, which is a bet on increasing volatility. The VXX, as described above, pays the roll yield when the futures curve is upward sloping as it is now, so short VXX will turn the contango headwind into a tailwind.
Below are 10 of the largest volatility linked funds and an estimation of the current monthly roll yield to long positions, based on each fund’s specific construction method.