Friday, December 21, 2012

Trading VIX Futures And The VXX: Forward Curve, Momentum, And Inter-Market Effects

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
At NAS Trading, we believe that VIX futures and the VIX ETN (VXX) currently present some of the best profit opportunities for individual traders.
What exactly are VIX futures? It is always best to go straight to the source. The CBOE education site states:
"The CBOE Volatility Index is based on real-time prices of options on the S&P 500 Index, listed on the Chicago Board Options Exchange (Symbol: SPX), and is designed to reflect investors' consensus view of future (30-day) expected stock market volatility... The contract multiplier for each VIX futures contract is $1000."
If you have ever looked at a chart of the VIX ETN note or VIX futures, it has likely occurred to you that this seems to be a great market to sell short. A cursory glance suggests that this market has a tendency to experience significant and prolonged downtrends that seem inevitable after each period of volatility ends.
This article looks to flesh out this tendency and gain a better understanding of how to profit from it. We will also look for times when it pays to go long both VIX futures and VXX.
Three factors that can be particularly useful to VIX traders are :
  • Forward curve dynamics
  • momentum effects
  • price signals from the SP500 futures contract
If you are not familiar with the effect the forward curve has on futures market returns (Or don't know what the forward curve is), I suggest that you read my article on the topic (here).
The forward curve relationship is particularly important in the VIX futures market, which in turn makes it very important for understanding price dynamics in the VIX ETN. Lets look at today's forward curve in the VIX futures as displayed on my quote board:

It is a bit easier To visualize in graph form:

As you can see, the market is in steep contango (upward sloping), which means that if the spot price does not change, then the futures contract will lose the difference between the forward price and the spot price between now and expiration. For example, lets consider the December 2012 contract, trading at 23.2. The current spot price is 17.74. This means if the spot price does not move, the December 2012 contract will have to lose 5.46 Points ($5,460) between now and expiration (spot price equaling contract price).
Now it is true the market usually anticipates a pickup in volatility during the fall, and it is not at all realistic to assume that the spot price will not change. However, the huge slope demonstrated in the forward pricing curve creates a massive headwind for longs, and tail wind for shorts. This is relevant to VIX ETN because this securities market exposure is created using VIX futures. If the VIX futures market is in steep contango, this will have a real effect on the NAV of the ETN.
I hope the above demonstrates why understanding forward curve dynamics is critical to successfully trading VIX futures or the VXX ETN. All else equal, steep contango is the short seller's friend, and backwardation (downward sloping forward curve) is the long side's friend.
The second factor we are going to look at is the "trend" or "momentum" factor. We are going to do this in two different ways. (Note: For this part of the study uses a continuous chart of the most liquid VIX futures contract from Jan 3, 2007 to September 4, 2012). Lets get started:
All else equal, would you rather sell short The VIX Futures contract after the prior day has closed up or down (based on the prior open to close relationship)? Lets examine the historical results:
  • For all days, the close to close return is .-0313, for a cumulative return of -44.87 (-$44,870)
  • For days where the prior open to close relationship was up, the return was .0217 for a cumulative return of 13.45 ($13,450)
  • For days when the prior open to close relationship was down, the holding period return was -.0741, for a cumulative return of -57.15 (-$57.150).
While these results are not strong enough to trade on their own, it does seem to suggest that using just a one day period, price weakness tends to be followed by price weakness, and price strength tends to be followed by price strength. As a side note, the Nearest month VIX Futures contract lost value (open to close) about 53% of all days during the past five years.
Next, Lets next examine Trend/momentum in VIX futures using a very simple Trend following system:
  • Sell Short when the 10 period moving average crosses below the 20 period moving average, buy back (cover) when the 10 period moving average crosses above the 20 period moving average.

The results are really quite remarkable but not entirely surprising, as are aware that the market has historically had a tendency to have prolonged downtrends. Total profit is $91,370, percent win is over 70%, and average trade is $3,514. Total trades is low, however this suggests that even when measured using this very short term trend signal, there is a high degree of trend persistence on the downside.
Lest you think I tweaked the inputs to get the above results, know this: Every moving average combination I tested between 10 and 50 was profitable, with an average trade profit between $800 to over $6000.
On to our final factor. I have seen that many traders attempt to use the VIX index to create trading signals for the SP500 futures or some other stock index contract. Lets consider the opposite. Lets see if a long term trading signal in the SP500 futures contract can have an impact on VIX futures close-to-close profitability.
We know that volatility tends to explode during significant markets declines. If we want to profit by shorting the VIX futures or VIX ETN, it would be nice to avoid these periods. Will a trend signal in the SP500 effect close-to-close returns in VIX futures? Lets check it out:
  • To start, lets consider that the average close-to-close return (as mentioned above) for VIX futures during our test period is -.0311, with a total loss of -44.87 ($44,870)
What is the average return from today's close to tomorrow's close, if today the SP500 mini contract closes above yesterday's value of the 80 period moving average?
  • The average daily loss increases to -.169, and the total loss increases to -137.15.
I tested this with moving average values between 30 and 200, and the results are logically consistent - meaning that pretty much every moving average length tested increased the average daily loss. This suggests that it is better to look for opportunities to short VIX futures when the SP500 futures are in an uptrend, as defined by our very simple trend signal (Today's close is above the X period moving average).
What about buying opportunities? If we flip around the above logic and test "What is the average daily return in VIX futures when the SP500 futures closed below the 80 period moving average" we find:
  • The average daily return jumps to .14, and the cumulative return is 92.6 points.
Lets add one more feature. What if the SP500 futures have closed below the 80 period moving average, and today's close in the VIX futures are greater than today's open?
  • The average return (close to close) jumps to .21, and the cumulative return is 66 points. The cumulative return is lower than the prior example because their are fewer simulated trading events when we include an additional parameter.
Based on the above, it looks like selling short VIX futures while the SP500 is in a downtrend is not a good strategy. In fact, results indicate that this is a good time to consider long trades. I have not examined it yet, however it would be interesting to see if the Forward curve effect coincides with the SP500 downtrend effect. I have observed that the VIX curve moves into backwardation during panics as the volatility, as the nearby contract ramps up - so this is possible.
Take away:
My analogy for these markets is that VIX futures and the VXX ETN trade similar to low quality, volatile stocks that are at times heavily promoted, (When they need to raise new equity to fund money-losing operations) yet have tendency to bleed returns after the stock promotion ends.
In the same way, bouts of market fear and volatility "fund" VIX trading products. The incredible "ramp up" of a volatility bull market scares shorts, yet ultimately the decline will once again set in. Our studies suggest that it is counter-productive for shorts to attempt to fight the market and sell short VIX products when upside volatility and momentum is positive.
This article is intended as "food for thought." Studies should be updated regularly in order to be in tune with changing market patterns. We will be tracking VIX futures and VIX ETNs in the subscription service.
Further reading:
Simon, David P; Campasano, Jim: The VIX Futures Basis: Evidence and Trading Strategies (Bentley University - Department of Finance, University of Massachusetts at Amherst - Isenberg School of Management)
Alexander, Carol; Korovilas, Dimitris: Understanding ETNs on VIX Futures (University of Reading - ICMA Centre)


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