VXX and why following VIX futures term structure contango signals may fail

Updated: Apr 8, 2019

One of the most commonly repeated strategy ideas I hear for investing in volatility ETPs is to base trade decisions on the shape of the VIX futures term structure, sometimes just referred to as "the VIX board."  You'll see this reckless advice posted everywhere, in blogs, on Twitter, in YouTube videos.  It drives me crazy, let me explain why.

To hear them tell it:

-  If the VIX futures curve is upward sloping (or in contango) this is seen as a time to short volatility with positions such as short VXX. 

-  If the opposite is true and the curve is downward sloping (or in backwardation) this is seen as a time to buy volatility with positions such as long VXX.

Could it really be this easy?  Do people really just have to "follow the shape of the VIX board" and money falls from the sky?  Unsurprisingly, no, very far from it.

If we plot the performance of this simple strategy since the VXX launched in January 2009, over the last nine years we can immediately see its shortcomings, and how it may have taken on more risk than many investors would have been comfortable with.

Strategy (blue):  If M2 >/= M1, short VXX.  If M2 < M1, buy VXX

So you can see there were some periods of tremendous success with that simple strategy like from 2009 - 2012, and also 2016 - 2017.  Essentially, half the time it works just fine and that's probably why today in late 2018 we still see certain volatility strategists recommending this type of signal.

However, I hope the chart also clearly shows you that this simple M2:M1 long/short crossover VXX strategy would have led to some excruciating drawdowns over the longer timeframe.  From the end of 2012 to the beginning of 2016, a total of 1071 trading days  (4.25 years)  that strategy produced a drawdown which reached a gut-wrenching maximum depth of -77.41%.


How many investors would have the risk tolerance to be able to sustain drawdowns of that magnitude and duration and stay the course?  I really hope the answer is none.

Despite some pockets of success, that simple strategy is no higher today than it was at the end of 2012, nearly six years ago.  That is a very long time to wait just to be at break even.  And what if a recession is on the horizon?  That six year period of no gains could easily turn into eight or nine.  

In fact, as you’ll see in the chart below, this M2:M1 long/short crossover VXX strategy has actually proved no better over the long run than just buying and holding a straight up short VXX position rebalanced daily, and I certainly hope nobody out there is doing that one either.  

Strategy (blue):  If M2 >/= M1, short VXX.  If M2 < M1, buy VXX Benchmark (black):  Short VXX buy and hold   (daily rebalanced)

That simple strategy of "following the shape of the VIX board" hasn't worked since late 2012 and that includes right up to now in September of 2018.  Truth be told, it would actually have been long VXX during the Volmageddon/Volpocalypse day on Feb 5th and made a 33.48% return in a single day.  So surely it must be doing very well so far this year right?  Not even close.  Despite a couple great days in February, it's given up all of those gains and then some and would still be down over -22% year to date.

Strategy (blue):  If M2 >/= M1, short VXX.  If M2 < M1, buy VXX

With all due respect to the average investor out there, the truth is most people don't know this simple fact, and there's no reason why they would right?  They have other jobs, families, hobbies, they simply don't have the time or investing experience to know and there's nothing wrong with that.  That's why they take advice from professionals that have put the work in and do know these things.

Now I apologize for being harsh here but I feel like 9 years in, we need to just call a spade a spade.  Despite numerous warnings from several of us in the volatility space, unfortunately, there was enough bad advice floating around out there that really caused some painful losses for people on Feb 5th.  I don't want that to happen to people again so I will say my peace now.  

If someone who claims to have an expertise in volatility investing even suggests something as uninformed as "following the shape of the VIX board" or any variation close to that, please just ignore/unfollow them.  They clearly haven't looked at any data with respect to what works and what doesn't when investing in volatility.  Twitter is chalk full of pretenders, and there's nothing that screams beginner more than those who suggest a contango/backwardation crossover is an actionable signal.  It's not.  It has already and it will again, fail spectacularly.   

So why is this underperformance happening? One of the problems with this type of strategy is that volatility in general can and does sometimes rise even when the VIX futures term structure remains upward sloping and in contango.  There are many examples of this since the inception of these volatility ETPs.  One of the more pronounced was in 2012.  Here's the VIX index nearly doubling in a three month period.  A fairly routine move to be honest, but how the VIX futures behaved is what I'm highlighting.

With the VIX index rising nearly 87% during that period people may assume that would have caused the VIX futures to invert into backwardation, and the simple strategy above to exit its short VXX position and move into a long VXX position.  However, that wasn't the case, and during that 55 trading day stretch, VIX futures contango mostly remained high averaging nearly 9%.

Here's how the simple M2:M1 long/short VXX crossover strategy would have performed over that time period. 

We're not talking about the strategy failing here when we're within 1-2% contango of the threshold.  In the above case, contango was very high averaging almost 9% and it was still a complete failure of a signal.  And it's important to note that while early 2012 was an obvious failure, there have been several others as well that have contributed to the now six years of flat performance.  Remember I showed above it's also failed miserably in 2018 as well.

So undoubtedly there's a lot more to volatility investing than simply following the VIX futures term structure, and looking at these charts should demonstrate the shortcoming of a simple volatility strategy.  While they may have brief periods of success when the markets cooperate, in the long run, the probability of excessive drawdowns is so high that it may surpass most people's level of risk tolerance.

It's ironic that one of the biggest advantages to volatility ETPs is also potentially one of the biggest liabilities.  This is the ease with which they can be purchased.  For the most part, they trade just like regular stocks and ETFs so there's very little barrier to entry, virtually anybody can buy them.

However, volatility ETPs are derivatives of derivatives and volatility markets are more complicated than stocks and bonds.  Just because volatility ETPs trade like stock does not necessarily mean everyone with an interest in trading stocks should trade volatility ETPs.  Especially since there is so much bad advice floating around out there.

In conclusion, the VIX futures term structure is an important piece of the volatility investing puzzle, but it's only one small part of a much bigger and very complex picture.  Certainly, there is potential for outsized return with these products, that's why the volume on them has remained fairly strong even after February 5th.  However, in my opinion, the only ones that will truly benefit in the long-run are those that focus on risk management and reducing drawdowns.  I will continue to educate and hopefully, all of us can stay safe and profitable for many years to come.