Simply looking at a graph of a VIX ETP like VXX or XIV doesn’t tell us much about the underlying forces at play in the VIX complex. ETP prices are merely the end result of the relationship between these underlying forces (which is why traders shouldn’t rely too heavily on price to guide trades, the way one might with say a stock index).
In the next four graphs, I show four of these key relationships year-to-date. These relationships are numbered 1-4 in the image to the right, which shows how volatility, the VIX, and VIX futures are most commonly aligned.
Long-time readers will note that these are the same four I covered in Four Graphs to Rule Them All as far back as 1986. Here I’m updating these graphs YTD to show our recovery from the major VIX spike in October.
Historical volatility (shown here as 10-day annualized standard deviation) is approaching baseline levels of the year, but still a ways off from late-August/early-September when HV approached 20+ year lows.
VIX futures have behaved mostly as you’d expect this year relative to the spot VIX. There has been a fairly constant premium over the spot during periods of market calm (i.e. contango), and futures have trailed the spot during significant spikes (i.e. backwardation, betting on mean-reversion to pull the spot VIX down).
As I noted in Four Graphs to Rule Them All, as you move from graph #1 to graph #4, the relationships illustrated become more and more important, but less and less consistent and/or predictable.
The fourth graph, VIX futures vs the future realized VIX, is really the key to the VIX trading game. Short-term VIX ETPs like XIV and VXX (for example) 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 VIX spot as they approach expiration.
VIX ETPs have been flat this year because, with the exception of April/May, the VIX complex has failed to maintain a consistent premium (positive or negative) between futures and the subsequent realized VIX. As that is a forward-looking relationship (futures today versus the spot in the future), I chalk that failure up to “stuff happens” rather than any fundamental shift in the VIX complex.
Where do we stand now? Despite VIX futures declining significantly since the major spike in October, futures are still higher than about half of VIX spot readings since the current bull run began in late-2011, and higher than 76% of spot readings this year. That means that, if this market can continue to remain reasonably calm, there’s plenty of room for futures to fall, and XIV/ZIV to rise.
With October’s VIX spike fresh in investors’ minds though, it’s yet to be seen whether we can return to the ultra-low VIX (< 12) seen this summer. That isn’t necessary for inverse VIX ETPs to gain mind you as premium will still exist with the VIX spot staying right where it’s at today, but it will make things more difficult.
Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.
Volatility Made Simple