Will Volatility Go Into Backwardation? How To Trade It

| About: iPath S&P (VXX)

A couple of months ago, I wrote an article on all the trading in volatility, specifically in volatility-tracking funds such as the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). This fund tends to lose money over time when volatility expectations are in a normal contango. That's when distant volatility is priced higher than near-term volatility.

That's generally the case as you can see in this chart of volatility futures that I published in my previous article in late March.

This is why VXX isn't that great a long-term portfolio hedge. When the near month is below the more distant months, a long VXX position loses money as contracts get rolled over.

In fact, during normal contango a short VXX position hedged against a long position in the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ) will generally provide a reasonable expectation of a profit. That's because the VXZ holds longer dated contracts, while VXX holds the shorter-dated contracts.

But with the recent turmoil in Europe, the contango looks as if it's disappearing and may go into backwardation. Here's an updated volatility futures chart year to date:

As you can see, the near month volatility futures contracts are trading a lot closer to the distant months. That means VXX could be a good long position to establish if you think that developments in Europe could take a turn for the worse (or the market heads south for other reasons).

Here's a look at how a hypothetical long VXZ/short VXX position would have performed year to date.

Notice that the position generated profits into mid-March, but has been flat since then. That corresponds to the volatility contango easing off in the futures market. If volatility goes into serious backwardation, this position will rapidly deteriorate. And it may be one of those times when reversing that position (or at least being long VXX) is the better trade.

It is true that VXX is not a good long-term hedge for a stock portfolio, but in the short-term, it's a useful tool for profiting from the "fear and panic trade." Consider that last summer, between July 15 and August 18 a $10,000 long VXX/$10,000 short VXZ position would have generated a profit of $5,000.

It would have been more had you held longer, but this is a short-term trade. It can go south on you quite rapidly when the more normal contango returns -- and it always does, eventually anyway. If the market really freaks out again like last year, I expect volatility to go into backwardation and that same type of trade would be a profitable one this summer too.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.