VIX futures trade at prices above or below the current VIX index level, depending on market participants' expectations of future levels of the VIX index. However, as VIX futures draw closer to expiration, the price of the future contracts converges to the current VIX index level. This occurs through the following mechanisms:
- VIX index increases/decreases to meet the current VIX future price
- VIX future prices increases/decreases to meet the current VIX index level
- A combination of 1 and 2 above
Unlike most other future contracts, the underlying spot price (the VIX index) cannot be traded directly. Therefore, a cash-and-carry-arbitrage trade cannot be made. The mechanism that causes convergence to occur each month is difficult to predict in most instances and is compounded by the VIX index's extreme daily volatility (7% standard deviation of daily returns since Q1 2006).
Generally, when VIX futures are in contango (future price above spot) they are more likely to decrease, and the opposite occurs when futures are in backwardation (future price below spot). The following chart summarizes the returns generated from shorting the iPath S&P 500 VIX Short-Term Futures ETN (VXX) when futures are in contango and buying the VXX when futures are in backwardation.
Click to enlarge all images.
As shown in the chart above, this VXX trading strategy more frequently produces a losing trade with a median return of -0.3%. This strategy does not work well because current month future prices trade at plus/minus 7% around spot price approximately 70% of the time since Q1 2006. Since under these circumstances the VIX index's standard deviation (7%) is greater than or equal to the premium from contango and backwardation, the VIX index can quickly increase or decrease greater than the premium from convergence. Large swings in the VIX index may cause the futures price to move against your position and reduce or eliminate gains from convergence.
However, the greater the contango or backwardation, the less likely swings in the VIX index will erode the premium gained from convergence. To find the optimal level of contango or backwardation to enter a position, I ran a Monte Carlo analysis at 200,000 simulations by randomizing the level of contango and backwardation at which I would enter and exit a position. I found the following to be the optimal strategy:
- Contango: Enter when futures are 16% over spot price. Exit when futures are equal to spot price.
- Backwardation: Enter when futures are 13% below spot price. Exit when futures are equal to spot price.
The following chart summarizes the returns generated from shorting the VXX when futures are in contango at the levels stated above and buying VXX when futures are in backwardation at the levels stated above.
As shown in the chart above, this VXX trading strategy is more successful than the previous strategy described earlier. Additionally, successful trades typically produce much larger gains than the losses from failed trades. Although fewer trades are executed under this strategy than the previous strategy, the number of days each trade is held is typically 2.5 times longer. As a result, a short or long VXX position would still be held 25% of the time during the period analyzed.
Although these returns from trading the VXX are impressive, I would consider implementing this strategy as a tactical complement to an existing stock and bond portfolio but not as a substitute for a diversified portfolio.
Disclaimer: Please consult your financial advisor before making investment decisions. Depending on your circumstances and risk tolerance, the strategy in this article may not be suitable for all investors.