Backtest: Comparing the VIX Index to Front Month VIX Futures

This is a test of another common strategy for trading VIX ETPs like XIV and VXX: comparing the VIX index to front month VIX futures. Traders often use this simple approach to judge whether the VIX futures term-structure is in contango (favoring XIV, or inverse volatility) or backwardation (favoring VXX, or long volatility).

For a test of a similar strategy, see comparing first and second month VIX futures.

Strategy results trading XIV and VXX are in blue, compared to buying and holding XIV, from mid-2004 to present.

20140315.ST_Equity-Curve

Strategy rules:

Go long XIV at today’s close if the VIX index will close below the front month VIX futures contract, or go long VXX if it will close above. 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.

20140315.ST_Stats

The strategy “works” by identifying when VIX futures are selling at a premium (discount) to the VIX index, meaning that futures will, all things being equal, tend to fall (rise) to meet the VIX index, benefiting XIV (VXX).

The strategy has been useful for detecting big drops in XIV in advance, but has done a poor job consistently staying on the right side of XIV during the bull run of the last 5+ years.

While this strategy has not been successful enough to stand on its own, I do think it’s one of many metrics that might be worth considering when trading VIX ETPs.

For example, even though this strategy (comparing the VIX to front month futures) is so similar in spirit to our previous test (comparing front and second month futures), the two have yielded very different results (monthly r2 = 0.44). Combining the two strategies might make for a moderately effective but extremely simple approach to trading VIX ETPs.

20140315.ST_Drawdown-Curve

20140315.ST_Periodic-Returns

When the strategies that we cover on our blog (including this one) signal new trades, we include an alert on the daily report sent to subscribers. This is completely unrelated to our own strategy’s signal; it just serves to add a little color to the daily report and allows subscribers to see what other quantitative strategies are saying about the market.

Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.

Good Trading,
Volatility Made Simple

Posted in Strategy Backtests.