The VIX Fix: The VIX Spread Trade

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Includes: VXZ, XXV
by: Jeff Klearman

Summary

The VIX Index is widely known as the “fear gauge” providing market participants insight into future stock market volatility.

Investable indexes use VIX futures contracts to gain exposure to the VIX Index.

The VIX futures curve is usually in contango, producing negative roll yield for long futures positions. This negative roll yield is usually greater for shorter dated futures.

The return of indexes long VIX futures is eroded by this roll yield while the return of indexes short VIX futures are enhanced but with high volatility and downside risk.

The “VIX Spread Trade” takes advantage of contango providing superior return performance with lower risk and lower correlation with respect to the broad equity markets.

Puttin' on the VIX

The CBOE Volatility Index (the VIX Index) has been around since 1993. VIX futures were introduced in 2004 with VIX options shortly following in 1996. Over the last year, approximately 237,000 VIX futures contracts traded each day with an average open interest of about 418,000. Widely known as the "fear gauge", investors, hedgers, speculators and observers look to the VIX as the portent of future stock market volatility. Yet as popular and pervasive as the VIX Index is, its performance - from a simple buy-and-hold viewpoint - is abysmal.

Now, the VIX Index itself is not investable. The index itself, broadly speaking, tracks 30-day implied option volatility on the S&P 500 Index. To "buy" the VIX Index an investor, hedger or speculator must enter into a futures contract on the index. And therein lies the problem. Futures contracts have fixed expiration dates. In order to maintain a constant 30-day exposure to the VIX Index, buyers must continually "roll" a portion of their futures position into the next available futures contract.

The process of rolling is in itself not the problem. The problem is that the forward implied option volatility curve of the S&P 500 Index, upon which futures contracts are priced, is usually upward sloping. In the jargon of the futures markets, this is called contango. When contango exists, rolling from a shorter dated futures contract into a longer dated futures contact is costly (generally referred to as negative roll yield). This is because rolling (ie, buying longer dated futures and selling shorter dated futures) will always mean entering into a futures contract at a higher level than where it is sold, all other things equal.

Investable Indexes

There are a number of investable indexes based on VIX Index futures. These indexes target a particular volatility maturity (for example, 30 days) and implement a systematic futures roll process using the appropriate VIX futures contracts. For example, an investable VIX index that seeks to track 30-day volatility would start out buying the 1-month futures contract and then systematically roll a portion of that position into the "next month" contract as each day passes, to maintain a weighted average expiration date of 30-days. My analysis in this article is based on S&P Dow Jones VIX indexes.

Below is a chart showing the 10-year performance of the S&P 500 VIX Short-Term Futures Index (ticker: SPVIXSTR), the S&P 500 VIX Mid-Term Futures Index (ticker: SPVIXMTR) and the VIX Index (all data normalized with start date level equal to 1). Both of the S&P Dow Jones VIX indexes include "collateral yield".

Because entering into futures contract positions doesn't require an outright use of cash, cash "invested" in the indexes is invested in short- term Treasury bills at whatever yield they provide. The chart shows a few important things. The first and not so easily discernible is that both S&P Dow Jones VIX indexes provide good exposure to changes in the VIX Index due to changes in S&P 500 Index option implied volatility. The second and more obvious thing the chart shows, though, is the erosion power of being long VIX futures contracts and rolling them while the VIX futures curve is in contango (this is generally referred to as negative roll yield). From 12/29/2006 through 01/06/2017, the short-term index, SPVIXSTR, declined 99.7% and the mid-term index, SPVIXMTR, fell 75.6%. Over this same time period, the VIX Index was almost unchanged. The third thing is that the mid-term index performance was more benign relative to that of the short term index mainly because the contango of the VIX futures curve is less steep further out on the curve than it is in up front.

See You On The Flip Side

If going long SPVIXSTR and SPVIXMTR provides abysmal returns, then surely going short them provides the opposite. And sure enough, it does. But with 2 serious caveats: large downside risk and high volatility. The chart below presents the 10-year performance of the S&P 500 VIX Short Term Futures Inverse Daily Index (ticker : SPVXSPIT) and S&P 500 VIX Mid Term Futures Inverse Daily Index (ticker: SPVXMPIT) (again, all data normalized with start date level equal to 1). Similar to above, both of these S&P Dow Jones VIX indexes include "collateral yield".

This chart, too, shows a few important things. The first is that going short VIX futures exposes investors to large downside moves and large volatility, especially when using shorter-term futures. The second and more obvious thing, though, is the potential earning power of being short VIX futures contracts and rolling them while the futures curve is in contango. From 12/29/2006 through 01/06/2017, the short-term index, SPVXSPIT, increased 281.3% while the mid-term index, SPVXMPIT, increased a more moderate 54.7%. Again, over this same time period, the VIX Index was almost unchanged (see chart above). The third thing, as in the chart above, is that the mid-term index performance was more benign relative to the short term index performance mainly because the contango of the VIX futures curve is less steep further out and because longer dated VIX volatility is, well, less volatile.

The chart below shows the annualized volatility for both indexes. The annualized volatility of SPVXSPIT over this 10-year period was a 67.4% while that of SPVXMPIT was 33.3%

Neither Too Hot Or Too Cold, Just Right

Finally, to the main point of this article: A VIX futures investment strategy that's not too hot and not too cold, but just right. And the investment strategy is: 50% long S&P 500 VIX Mid-Term Futures Index (ticker: SPVIXMTR) and 50% longS&P 500 VIX Short Term Futures Inverse Daily Index (ticker : SPVXSPIT), rebalanced monthly. To be clear, this trading strategy is a spread trade which, in essence, goes long mid-term VIX futures contracts and short short-term VIX futures contracts. The performance of this strategy is given in the chart below. For comparison, the performance of the S&P 500 Total Return Index (SP500TR), the SPVXSPIT and the SPVIXMTR are included on the chart as well. Again, all data are normalized with start date level equal to 1. Similar to above, both of the S&P Dow Jones VIX indexes include "collateral yield".

What's clear from the chart above is the VIX Spread Trade (ie, 50% long SPVIXMTR and 50% long SPVXSPIT, rebalanced monthly) had over twice the return of the SP500TR over this 10-year period and only a slightly lower return than SPVXSPIT but with much, much lower volatility and drawdown risk. In fact, the annualized volatility of the VIX Spread Trade is actually slightly lower than the SP500TR over this 10-year period. In addition, the VIX Spread Trade has a moderately low correlation to the SP500TR (54.2% over this 10-year period), allowing it to act as a diversifier to the broad equity market.

The table below lays it all out.

But what's most interesting about the chart above is the performance of the VIX Spread Trade in 2008-2009. As can be seen, its drawdowns were much lower than both the SP500TR and the SPVXSPIT. Broadly speaking this is because the VIX Spread Trade is flat outright VIX futures exposure and only exposed to the shape of the VIX futures curve. But there are other things going on here. Specifically, SPVXSPIT rebalances daily, reducing its short VIX position as futures prices increase, in essence limiting its max loss to 100% while, as can be seen in the chart, SPVIXMTR has no limitation on its max gain (this was especially relevant in 2008-2009 when SPVXSPIT declined nearly 90% in value due to extreme market conditions). Offsetting this positive performance characteristic, however, is the fact that the VIX Spread Trade rebalances monthly, in essence re-allocating gains to SPVXSPIT and reducing exposure to SPVIXMTR as it increases more than SPVXSPIT decreases. These two opposing factors actually improve the overall performance characteristics of the VIX Spread Trade.

The VIX Rub

The VIX futures curve is usually in contango, creating negative roll yields for long futures positions. This negative roll yield is usually greater with shorter dated futures contracts compared to longer dated.

The performance of investable VIX indexes is affected by this roll yield. The return of indexes long VIX futures contract is eroded by this roll yield while the return of indexes short VIX futures contract is enhanced. However, indexes short VIX futures contracts are subject to large volatility and drawdowns (eg, during stressful market conditions).

The VIX Spread Trade, 50% long SPVIXMTR and 50% long SPVXSPIT, rebalanced monthly, takes advantage of the VIX futures curve contango providing superior returns to the SP500TR with comparable or lower volatility. The VIX spread trade also acts as a diversifier to the broad equity market, having a relatively low correlation of 54.2% to the SP500TR.

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.

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