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 how four of these key relationships played out in 2014. 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. Note that I’ve also included YTD data for 2015 to capture our most recent VIX spike.
Historical volatility (shown here in grey as the S&P 500’s 10-day annualized standard deviation) is running hot at the moment, currently in the top third of readings since the VIX’s inception. The most recent uptick in HV is the result of two big up days for the equity market, hence the reason you see the VIX falling in response.
VIX futures behaved mostly as you’d expect in 2014 relative to the spot VIX. There was a fairly constant premium over the spot during periods of market calm (i.e. contango), and futures 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.
The VIX complex did a very bad job in the second half of the year predicting the future as it failed to maintain a consistent premium (or discount for that matter) between futures and the subsequent realized VIX. As this is ostensibly 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 coming down from their recent highs, futures are still higher than about 80% of VIX spot readings since the current bull run began in late-2011, and higher than 90% of spot readings in 2014/15. 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.
Having said that, in the back of VIX traders’ minds should always be the fact that at some point the low volatility regime of the last few years will come to an end. VIX futures are very much average at the moment relative to the entire history of the VIX spot.
Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.
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