Trading volatility using the VIX Index typically involves a set of strategies for speculating on market volatility. These strategies usually have a high risk, but also a high return and use VIX derivatives. The VIX, often called the ‘fear index,’ reflects the expected volatility of the stock market based on S&P 500 options. Direct trading of the index is not possible; instead, futures and instruments that emulate a combination of futures contracts – ETFs, ETPs – are used.
Contango and Backwardation: States of the Futures Curve
The VIX futures curve usually exists in one of two states: contango or backwardation. Contango means that the prices of futures with later expiration dates are higher than those with nearer expiration dates:
Backwardation is the reverse situation, where the nearest contracts are more expensive than the distant ones.
Why is the Market Most Often in Contango?
For the most part, the VIX futures market is in a state of contango. For instance, during the period from 2006 to 2023, futures were in contango 80% of the time. This is because investors typically expect greater volatility in the long term compared to the short term (a longer period encompasses more risks). Additionally, market participants often use VIX futures as a hedge against a stock market decline, which also helps maintain contango.
The situation where the near-term contract is almost always cheaper hints at a very simple trading strategy – always sell the second contract. This strategy became particularly popular with the introduction of VXX – an Exchange Tradable Note, which represents a combination of the first and second futures. A rollover occurs every day – part of the position in the near-term future is sold, and the distant future is bought. Such an instrument should lose some of its value each day – we sell the cheap near-term future and buy the expensive distant one. In reality, on average, this is what happens:
This chart shows the adjusted price of VXX since its launch. It would seem that a simple short of this ETF would yield excellent returns.
However, during market downturns, VIX futures behave very differently.
- Their price increases sharply, by multiples. Therefore, a regular short would quickly leave an unlucky trader without funds
- The futures curve shifts into a state of backwardation (the second future is cheaper than the first), and every day in position results in losses.
To try to mitigate risks, there are two main groups of approaches:
- Filters for different market states. That is, not just staying short on the distant future all the time, but trying to identify those moments when such a position is most profitable and safe.
- Hedging risk using additional option or futures positions.
Such strategies were especially popular during the 2010-2017 period. There were many websites describing similar strategies and analyzing their effectiveness. Quite popular was volatilitymadesimple.com – this site posted descriptions of strategies and their current results. The site’s team traded some proprietary version of their own – possibly a combination of some strategies, or their modification. And then came February 2018. As a result of the Volmageddon (reference here), volatility traders suffered huge losses. For example, SVXY – an ETF inverse to VXX – lost 96% of its value at one point, and its twin brother XIV was even liquidated.
These events might have negatively impacted volatility sellers. For one reason or another, volatilitymadesimple ceased to exist. But the idea of accumulating and tracking volatility trading strategies seems interesting.
We checked the performance of the VIX strategies package to the current date.
Existing strategies compiled into a combined portfolio with equal weights. Some strategies have been adjusted. We consider that due to contango in most situations, it’s better to either stay out of the market or short volatility instruments (when strategies indicate this). So if the basic approach suggested going long on volatility, the entry conditions were tightened or it was even completely excluded.
Modifications were made before the testing phase. Overall, the results cannot be called bad, even considering Volmageddon or similar events (March 2020 – Covid crash).
We will continue to update and expand the database of volatility strategies, track their performance, and further adjust the composition and weights of the portfolio to improve returns.
Please note, the results of the test portfolio are not investment advice and are presented for research purposes. Trading volatility without proper hedging is very dangerous. Our own strategy differs from this basic portfolio and actively uses hedging instruments.
Test results of the combination of 22 VIX strategies (equal-weighted):
Key performance metrics (2010 – 15 Dec 2023)
| Averaged VIX Portfolio | Benchmark: Short VXX | Benchmark: SPY | |
| Full Return | 28 456% | 5 850% | 549% |
| Annualized return | 50% | 34% | 12.95% |
| Max DD | -47% | -92% | -34% |
| Sharpe ratio | 0.91 | 0.42 | 0.70 |
Strategies:
VIX Futures: F1 vs F2, VIX vs F1 Futures, VIX vs 30days Constant Maturity, VIX vs VIX3M, VIX vs VIX3M VM, VIX HistVol, DFTB’s Spread Strategy, DDN MOM ETF, DDN VRP, VXX SMA 10/100, TWP VIX3M Regression, VIX CM SMA 10/20, DDN VRP Optimized, VXX Bollinger Bands, VXX SMA 5/15, Evolution Capital VIX Futures, TTO VRP, VIX EMA/SMA, Macro Investor VIX Futures, QT VIX3M:VIX6M, Godot Mojito