VIX Trading Year-to-Date in Four Graphs

VRP Explained 2Simply 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 I think traders shouldn’t rely too heavily on price to guide trades, the way you 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 relationships I covered in Four Graphs to Rule Them All as far back as 1986. Look for explanatory verbiage after the graphs.

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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.

As I’ve noted many times though, just because this overestimation is consistent doesn’t mean it’s a free lunch. One significant volatility event can wipe out a long period of peacefully capturing the premium described above. Successfully navigating these changing periods is the key to long-term successful VIX trading.

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

Good Trading,
Volatility Made Simple

Posted in Real-Time Analysis.