This is a test of a common strategy for trading VIX ETPs like XIV and VXX: comparing first and second month VIX futures. Traders often use this simple approach to determine whether the VIX futures term-structure is in contango (favoring XIV) or backwardation (favoring VXX).
Strategy results trading XIV and VXX are in blue, compared to buying and holding XIV, from mid-2004 to present.
Go long XIV (VXX) at today’s close when the front month VIX futures contract will close below (above) the second month. Hold until a change in position.
Wonk notes: Transaction costs and slippage are assumed to total 0.1% of each trade (0.2% round-trip). Return on cash has been ignored. Data prior to the launch of each ETP has been simulated back to 2004. We’re able to do this accurately using a combination of the indices and the futures data on which these ETPs are based. Read more about simulating data for VIX ETPs.
Were it not for the 2007/08 market crash, a case could be made that this strategy has been successful. In terms of terminal wealth, the strategy would have posted big returns to the tune of about 46% annualized, but the strategy failed so miserably in the 2007/08 crash that no reasonable investor would have stayed the course and I put little faith in the strategy navigating the next market crises.
Why the 2007/08 failure? As the next graph shows, front month VIX futures remained below second month VIX futures for most of the first part of the 2007/08 crash in XIV, and then were schizophrenic (and repeatedly on the wrong side of things) until late 2008.
XIV is in blue (left scale) and the difference between first and second month VIX futures is in grey (right scale, negative values indicate contango).
For the sake of completeness, a drawdown curve (also known as an underwater equity curve), as well as monthly/annual returns for the strategy follow. Note too how the strategy has significantly underperformed XIV over the last 1+ year.
In future posts we’ll continue to cover other common approaches to trading VIX ETPs. Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.
Volatility Made Simple