Volatility ETF Trading Strategies - Part 1: VIX futures

* I’ll update the charts and commentary in these very old articles every now and then so that the data is stretched over longer periods of time. Last updated Nov 2015 *

In this series of five posts I’m going to be going into a little more detail about some of the most common methods of trading the various volatility ETP’s such as XIV and VXZ. I think it’s important that subscribers in the VTS community at least have a basic understanding of the complexity of these products as well as some of the potential drivers of possible strategies. The five part series will cover:

VIX Futures Term Structure Volatility Risk Premium (VRP) Mean Reversion 30-day Constant Maturity VIX : VXV Ratio

Part 1: VIX Term Structure

This is arguably the most common indicator traders use to predict future price movements in the XIV. You can learn more about the VIX futures term structure here, and the reason why we use it is due to how the XIV derives it’s price. It’s not based on supply and demand as many other securities are, but instead it’s based on a set of rules that constantly rolls buying and selling of the first and second month VIX futures values such that it’s a constant 30-day maturity weighting.  However the VIX futures values have to converge to the spot VIX value by the expiration date, so this creates what is known as roll yield. If the VIX futures are upward sloping or in contango as it’s called, the roll yield will mathematically tend to add small amounts of value to the XIV as it converges day by day to the spot VIX. In times of backwardation or a downward sloping futures curve the opposite is true.

So that probably all sounds very complicated which is why these products are only to be traded by those with years of experience in the volatility space, but essentially any system based on timing the VIX futures term structure is trying to capitalize on this roll yield.

If a trader was long the XIV during times of contango, and long an inverse product like VXZ during times of backwardation, how would they have done in live trading?

* I’m using January 2013 – present in this example because live trading at Volatility Trading Strategies began in January 2012 and I want to give it a year for a little more robust comparisons.

To date that simple system would be profitable, but quite inconsistent with a fair number of significant drawdowns along the way. The key to long-term investing success is minimizing drawdowns and that simple VIX futures term structure following strategy is just far too wild to dedicate any serious capital to.

For reference here are our VTS Tactical Volatility Strategy results for the same time frame:

We definitely use the VIX futures term structure as a part of the overall system, but on it’s own it doesn’t come close to telling the whole story of how these products trade.

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