Free Money: The VXX And VXZ Pair Trade

| About: iPath S&P (VXX)

Summary

Shorting the VXX is a dangerous game, even in a contango play.

Studies have shown that volatility contango trades fail to live up to the theoretical potential gains.

I offer an alternative way of reaping contango income without the downside risk that comes with shorting VXX.

The resulting strategy outperforms the SPY by 100%.

Seeking Alpha contributor Force Majeure wrote an incredibly insightful article on why the volatility carry trade does not live up to the hype. Essentially, the carry trade leverages the difference in contango between the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ). The trade is to go long VXZ and short VXX.

I refer readers to Force Majeure's article for the explanation for this trade failing. But another explanation for the overall failure of this trade lies in the simple fact that going short VXX, while a smart idea in the long term, can devastate your account during those semi-rare price spikes in the VXX. As long as you're short on VXX, nothing can save your portfolio or the dreaded margin call.

No, not even VXZ can save you, as VXZ spikes are significantly smaller than VXX spike, as you will later see. Thus, while theoretically hedged on volatility via being long VXZ and short VXX, you are actually always short on volatility, especially when volatility is rising. This logic of this trade explains it all: You're chasing contango profits while being short on volatility.

The Solution

When I see an opportunity, I know we must have a way of working it into our favor. Contango on the VXX and VXZ certainly is an opportunity. We just need to know how to play it.

But first, let's be realistic: Volatility is not an investment. It's a hedge at best. It does have a place in the investor's portfolio as a long position for hedging and possibly as a short position to gain contango exposure.

Can we get the best of both worlds? Can we make the VXX/VXZ strategy work? Yes. It only takes a bit of thinking and backtesting to see why.

While the contango spread in Force Majeure's article looks attractive, let's accept the fact that the long VXZ, short VXX trade fails because of the price spikes in VXX. A chart will show why being short VXX is dangerous even while hedged long VXZ:

Click to enlarge

While we are playing the contango trade and profiting, we are also exposing ourselves to huge risks, namely market corrections. The chart above shows how a short VXX trade would have eaten up 40% of your gains twice per year last year, possibly triggering a margin call. If we cannot predict market corrections, we cannot play contango safely.

However, one interesting fact we can draw from the chart above is that it seems to be a rule that the VXX overtakes the VXZ in the event of a correction or crash. That is, when VXX overtakes VXZ, our short position is at risk. Had VXZ stayed below or even with VXX, we could have safely gained from the carry trade.

What if we could avoid those drawdowns by reversing our trade whenever the VXX surpassed the VXZ? If we reversed the trade, the drawdowns would then become gains. I backtested this strategy with the following rules:

  1. Run the long VXZ, short VXX carry trade as long as VXX was less than 10% above VXZ.
  2. Switch to a long VXX, short VXZ trade when VXX exceeds 10% of VXZ.

That is, when VXX is clearly above VXZ, therefore implying an imminent market correction or crash, we reverse our pair trade to avoid being exposed to the short side of volatility. We remain exposed to contango because we are now short VXZ. Yes, this is the opposite of the intended carry trade, but with VXX increasingly exponentially more quickly than is VXZ, the growth in VXX exceeds the ETF's decay at the hands of the futures rollovers.

In other words, we simply switch to a slower contango trade until the markets settle back down, at which point, we reopen our fast contango trade. This trade seems to work, according to the backtest. By the way, note that as per Force Majeure's article, we are using a beta of 0.45 over the period of 2009 to now, meaning that the position should be at a ratio of roughly 2:1 long VXZ, short VXX:

By focusing on the contango of VXZ during rough times in the market, we produced a winning trade over the long-term. Thus, the opportunity to profit from a VXZ/VXX pair trade is there, but it really is a trade - not an investment. You will need to switch the long and short positions roughly 4 times per year, according to the events of last year.

Still, it is apparent that this strategy beats the SPDR S&P 500 ETF (NYSEARCA:SPY) in terms of long-term gains. Investors who wish to profit from volatility contango can do so with the above strategy, but they must be willing to deal with their profits being taxed as ordinary income. This is seemingly the only reliable way to profit from VIX contango.

Learn More about Earnings

My Exploiting Earnings premium subscription is now live, here on Seeking Alpha. In this newsletter, we will be employing both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I will also be offering specific strategies for playing those earnings reports.

We have accurately predicted earnings surprises 100% of the time (8/8). Our latest report was NVDA, for which we predicted a positive earnings surprise.

This week, we look at and Cisco (NASDAQ:CSCO).

Disclosure: I/we 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.