It’s amazing how often I see comments online, in blog posts, on Twitter talking about how all you need to do to succeed in trading volatility products is follow the VIX futures term structure. If the front two months are upward sloping or in “contango” you buy XIV and if they are downward sloping or in “backwardation” you buy VXX. And you can get that simple information by logging in to VIXCentral.com and checking the VIX futures term structure.
I’ve shown many times in the past the performance of this type of strategy. Here it is as of today:
Clearly there are times when that type of strategy works, but there’s also been periods where it fails spectacularly. Who out there could stay the course from 2013 to 2016 with that strategy? 4 years and a 77% drawdown of capital? Hopefully nobody.
So clearly this strategy is a non starter, but why? If you remember, the XIV net asset value is derived from holding a composition of the front two months of VIX futures, so how is it possible the performance could be so poor? Well this past week has shed some light on the problem:
The VIX Index, and by proxy volatility in general, can and does sometimes rise even when the VIX futures term structure is upward sloping and “normal.”
And of course if volatility rises that’s likely going to have a negative effect on the inverse volatility products like XIV, SVXY, and VMIN. So even when it’s normal those products could still suffer losses.
Check out the VIX Index action from the past 5 days.
On a 10 minute chart, the VIX Index has risen from a low of 9.50 and touched a high of 14.51 in just the last week. That’s an increase of 52.7%. So has the VIX futures term structure reflected this large 5 day VIX move?
Not really. The VIX is high relatively speaking, but contango is still at a fairly normal level. There may be more to this and things could change rather quick here, but we’ll see.
The reason I mention this is to hopefully communicate to people that investing in volatility products is actually pretty complicated.
Simplistic strategies such as the commonly quoted: “If M1 > M2 you buy XIV” won’t yield consistent long term results. And should this come as much of a surprise?
That a derivative of a derivative of a derivative is complicated?
There’s a lot of investors out there who are trading these volatility products who probably couldn’t define the VIX Index, or explain what VIX futures are, or understand what implied volatility and the volatility risk premium is.
There’s nothing wrong with that of course, I’m not criticizing. I’m sure there’s countless professions out there where I couldn’t even begin to speak intelligently about them.
I couldn’t explain how to build an earthquake proof bridge for example. There’s nothing wrong with that, but that’s also why I don’t build earthquake proof bridges. I don’t know how. I could probably build something that looks right on the surface, but I’m sure it would fail miserably as soon as the ground started to shake.
Yet because of how incredibly easy it is to buy a simple Volatility ETP (essentially they just trade like any other stock) there’s a lot of people who perhaps shouldn’t be buying them that are.
Their strategy may look right and act right on the surface in good times, but as soon as the ground starts to shake it fails.
The VIX futures term structure should only ever be one part of a broad strategy. I use it in my trading for nearly all of my investment strategies, even the ones that trade stocks, bonds, and gold, it’s still very useful.
But it’s only ever one small part of the big volatility picture.
There’s many other indicators as well that need to be taken into account. Obviously I can’t give away all my proprietary secrets, but in my explanation of the VTS Tactical Volatility Strategy I did try to give a lot more information than is commonly seen elsewhere. If you haven’t seen it yet, or haven’t seen it in a while, I invite you to give the video a listen.
* It’s one of my first ever videos so please forgive the sales pitch vibe and just focus on the information 🙂
** And feel free to fast forward to the 5:30 mark in the video where I begin to explain the strategy.
Ask me any follow up questions about anything within, and outside of giving away the secret recipe I’ll elaborate as best I can.
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