In this post I show 4 graphs that illustrate the root of returns for most VIX ETP swing-trading strategies (1).
This post is long on data and short on verbiage, but the image to the right (click to zoom) is a cheat sheet. The 4 yellow lines correspond to the relationship each of the 4 graphs is describing. The image shows how volatility, the VIX, and VIX futures, usually relate to one another when contangoed (which is most of the time).
None of this is new, but I think it’s important enough to us VIX ETP traders that we occasionally take a moment to re-meditate on it. Note that as you move from graph #1 to graph #4, the observations illustrated become more and more important, but less and less consistent and/or predictable.
The last graph (#4) is really the key to the ballgame. Short-term VIX ETPs like XIV and VXX are perpetually shifting towards the second month contract to maintain a 30-day constant maturity. As long as futures are consistently overestimating the subsequent realized VIX, there will be money to be had in this trade as VIX futures are forced to converge to the spot VIX as they approach expiration.
Volatility Made Simple
(1) I say that these graphs illustrate the root of returns for “most” VIX ETP strategies because some very short-term strategies (such as TM’s RSI(2)) are based on predicting the overall level of VIX futures, not based on capturing the volatility risk premiums illustrated here.
(2) For all dates prior to 1990, I used the VXO index in place of the VIX index. It’s an imperfect comparison, but close enough I think for the purposes of this illustration (and it’s useful to be able to capture the 1987 crash).
(3) Because I used the 30-day constant maturity price, graphs #3 and #4 are relevant to short-term VIX ETPs like XIV and VXX, but the conclusion would essentially be the same had we looked at a longer-dated constant maturity for mid-term VIX ETPs.