This strategy is based on the following premises:
- Under normal, non-stressful conditions, the volatility futures curve is in a state of contango, where near-term futures are priced lower than far-term ones. This pricing pattern occurs because a longer timeframe typically includes greater uncertainties and risks compared to a shorter one.
- There are instruments, such as ETFs and ETPs, designed to track the volatility index by holding the nearest two futures contracts. These instruments constantly roll over their positions, typically selling the near-term (often cheaper) contract and buying the next-term (usually more expensive) contract. In a typical market environment, this strategy leads to a consistent loss of value for these instruments. One example of such an instrument is VXX.
- During market panic situations, however, the price of the near-term futures contract typically exceeds that of the far-term contract, as market participants are more concerned about the immediate behavior of the indices. The state of the futures curve, therefore, not only offers the potential to collect a premium in a contango environment but also serves as an indicator of overall market behavior.
It’s generally believed that, due to contango being prevalent most of the time, the preferable strategy is to either remain out of the market or to short volatility instruments.
Thus, we can create a fairly simple strategy: shorting instruments that typically lose value due to contango in normal market conditions, and avoiding the market during periods of atypical behavior. A similar approach can be applied to other VIX ETFs or directly to VIX futures. One major advantage of using futures is that there’s no need to pay a short rebate to the broker, which can amount to about 3% per year and is not included in other costs. However, trading in VXX often offers greater convenience due to its high liquidity and smaller price increments.
Strategy Rules:
Short VXX at the market close if the front month VIX futures (F1) contract is priced lower than the second month VIX futures contract (F2). Out of position otherwise.
Strategy Performance
Test period: 2010 – 15 Dec 2023. Costs (brokerage comissions, slippage and borrow cost) are not included.
| Averaged Strategy | Benchmark: Short VXX | Benchmark: SPY | |
| Full Return | 25 339% | 5 850% | 549% |
| Annualized return | 48.6% | 34% | 12.95% |
| Max DD | -65% | -92% | -34% |
| Sharpe ratio | 0.72 | 0.42 | 0.70 |
