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The volatility contango returned with a vengeance after I wrote an article suggesting a bullish options trade on the iPath Short-Term VIX fund (NYSEARCA:VXX). It was a hypothetical trade which would have resulted in a $500 loss at the open on Monday.

But Friday? That was "pre-Greekend" ancient history. Take a look at this chart as of Monday's close:

(click to enlarge)

I sort of thought that given the uncertainty in Europe, we'd get a move more like the ones shown by the purple arrows, which occurred earlier this month and last month, but we got just the opposite.

When the term structure moves up to become more flat or even appears to flirt with going into backwardation, VXX does tend to rise, but when the term structure moves back into contango, VXX drops like a rock, in some cases even if the VIX is rising.

The reason is that not all VIX expiration months are created equal. Consider this: On Friday, the July VIX futures were down by more than 5%, but the December contract was down only 3.9% with the spot VIX down 2.6%. On Monday, the July contract fell almost 8%, but the December contract was down less than 2%.

One commenter on my post suggested that the VXX and the VIX relationship had "broken down."

Subject to contango and backwardation, I thought there was at least some correlation between the VXX and the VIX. What I have been finding for a couple of weeks, at least, is that the relationship has completely broken down, with the VIX up today but VXX tanking; the other day it was the reverse, with VXX up and VIX down.

Black box warning

This should probably appear near every single quote you see for the VXX - a "black box" warning so to speak. It comes directly from the VXX prospectus:

Yes, there is some correlation sometimes between the VIX and the VXX, but the VXX is definitely hostage to that contango. I suspect we may see the volatility term structure go into backwardation sometime this summer, but we'll need another catalyst. Spain? Italy? Some other continent? Who knows?

Source: Volatility Contango Strikes Back