Yesterday’s chart that showed the performance of a simple VIX futures term structure strategy sparked more than a few “oh wow I didn’t know that” type of emails today.  And I’m not surprised by this reaction because trust me I’ve seen just as many articles as you have that talk about this simple strategy as the holy grail of volatility investing.

Here it is again:

If M2 > M1  (contango)  Buy XIV
If M2 < M1  (backwardation)  Buy VXX

The S&P 500 hasn’t even dropped 5% in well over a year so of course recently this strategy is a success, but under any normal market conditions it’s not something any long term investor should get too excited about.

The XIV was down again yesterday making that 7 days in a row that it’s taken losses, yet the VIX futures term structure is completely normal and strongly in contango.  (currently 10%)

Our friend Ray asks:

“Has something like this happened before, or is this the sign of a major volatility regime change?”

On the regime change point, unfortunately that’s just something we’ll know after the fact.  I know right, not very helpful, but nobody can predict markets so we’ll just have to take what comes.

But on the “has something like this happened before” point, yes it has, I remember it well.

March – May of 2012

On a strong VIX move like that the VIX futures term structure must have gone negative and tipped traders off early right?

Not until the last day would a VIX futures term structure following strategy have exited the position.  But of course by then the damage was done.  XIV was down 36% already.

But the carnage didn’t stop there.  The VIX futures term structure had more surprises when it bounced strongly, yet STILL the VIX was rising.  Let’s extend it another month into June:

So in the end, how did a VIX futures term structure following strategy do during this period?

Ugly ugly.  A 51% loss of capital during a period where VIX futures contango was normal and averaged nearly 10% over the 3 months.

If there is a moral to the story here, it’s that during good times there’s plenty of strategies that can achieve some good performance numbers and we’ve seen a lot of that in the past year and a half.  Like I said, the S&P 500 hasn’t even flinched in quite some time.

During bad times however, and especially during outlier periods it’s extremely important to have a much more comprehensive understanding of this complex volatility space.

I never say this to scare people, just to inform.  Volatility ETPs are exciting and can absolutely add dynamic growth to a diversified portfolio.  Personally I can’t imagine my portfolio not having a nice little allocation dedicated to them.

But if mishandled they can be a portfolio melting disaster so we need a more extensive approach.  Multiple volatility indicators, multiple data sources, and a comprehensive approach that isn’t afraid to hold cash when things are ambiguous.

Volatility ETPs, VIX futures, VIX options, S&P 500 options, the level upon derivatives of derivatives of derivatives can be dizzying.  Again the VIX futures term structure is an important indicator, but it’s only one cog in the volatility wheel.


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