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VIX, Peso… Sometimes you just cannot trade it!

August 9th, 2010 · 5 Comments · Futures

Or a case for going short VIX despite high bullish consensus?

I have been going on about roll yield and term structure for a few posts, and through two very concrete examples we’ll see how it can affect your trading and system development

A reader recently mentioned a paper (pdf by Sloyer and Tolkin) presenting a theoretical trading strategy which improves the risk-return profile of standard equity-bond portfolio by adding allocation to equity volatility represented by the VIX index. The idea sounds good on paper (no pun intended), but a “small” assumption might render the strategy impossible to implement practically:

VIX futures can realistically be included as an asset in a passively managed portfolio as the futures can be rolled relatively cheaply from one contract to the next as each contract expires.

The Current VIX Situation

Taking a look at the current VIX futures curve clearly invalidates the assumption above:

VIX futures curve - click to zoom in

VIX futures curve - click to zoom in

At the current levels, the contango rate is over 100% annualized – definitely no “relatively cheap” roll yield. As we’ve seen with the contango exhibited in Crude Oil in 2009, futures performance failed to match the spot price – and with such a high contango rate in the VIX futures, the same would happen: spot price returns would be “eaten away” by the negative roll yield. Indeed, prices would have to raise by an annualized 100% just to counter the contango.

Sometimes a good theoretical idea fails at the practical implementation stage…

Mexican Peso: Same Concept, Opposite Effect

Coincidently, another reader was offering me a friendly warning regarding the use of spot market to drive signals for a futures trading strategy – as was described in Better Trend Following through improved Roll Yield (note: for practical reasons, the test in that post was done using front-month contract as a proxy for the spot market).

In effect, as is the case in the VIX futures, the roll yield part of the total return sometimes trumps the spot price moves. In these cases, looking solely at the spot market can be flawed.

This is very well illustrated by this Peso chart sent from our reader:

The black curve almost continuously going down is the spot price, whereas the blue curve is a continuous futures contract (back-adjusted using front-month contracts) - click to zoom in

The black curve almost continuously going down is the spot price, whereas the blue curve is a continuous futures contract (back-adjusted using front-month contracts) - click to zoom in

The strong divergence between both series meant that an investor/trader going short on the Peso, would have been “right” (ie. the Peso unarguably went down), yet would have lost money if using futures to implement her trade (as highlighted by the futures continuous contract going up).

This is another case where the roll yield has a stronger impact than the spot price move.

Two Conclusions

Despite the spot price usually grabbing most of the attention, the roll yield can be the driving factor to a futures market’s total return. This can seem counter-intuitive but on long-term timeframes, roll yield explains most of the market’s performance (as discussed in this separating the wheat from the chaff paper I have linked to previously).

When looking at potential trades (in futures, or ETFs, which are sometimes no more than futures “wrappers” or even forex with cost of carry), one should weigh the spot price return potential against the term structure implied return. From a system development point of view, an idea might be to add a portfolio ranking/filter based on the implied yield vs. ATR (or other measure of “volatility”).

The second conclusion is that the market seems to reward those who trade against conventional wisdom. In that period covered by the Peso chart, most people were worried about further devaluations and were paying dear to hedge against this outcome. The hedge ended up costing them more than the cost of holding on to a devalued Peso. Alpha is finite and flowed to the minority being long the falling Peso…

Maybe time to short the VIX futures?

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5 Comments so far ↓

  • TopTick

    Selling volatility is, of course, a widely used strategy — very reliable, until it blows up on you.

    One mitigation would be seasonality. Even before 2008, monthly returns for October showed the largest standard deviation and largest range (max to min) over history. (As Mark Twain had it over a century ago: “October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”)

    Nonetheless, I wonder if the current contango in VIX is a seasonal wariness of going into September and October.

  • Andrew

    I note that the chart for Peso futures is forward-adjusted. What, if any, difference would it make to your analysis if the series were displayed as a back-adjusted chart?

  • Jez

    Funny quote… The “recommendation” to sell VIX was more a “tongue-in-cheek” conclusion rather than anything serious

    The forward-adjustment ensures that the futures price starts at the same level as the spot price to show how series evolve over time from teh same starting point.
    With back-adjustment, the futures series would end at the same level

  • Pumpernickel

    The common wisdom “test what you trade and trade what you test” would keep you out of trouble here. The blue line on the peso chart is that-which-you-trade; since it is flat-ish to rising, either “out” or “long” positions are indicated. Going short because some other instrument that you don’t even trade (“the cash”) is falling, is a bit silly.

    That-which-you-trade in the VIX is shown in this chart It suggests that shorting VIX futures was sensible and profitable in 2009 and Q1 2010; with typical stoplosses you would have exited short in early May (giving back some profit but with a bundle still in your pocket), and the typical stoploss would have gotten you out before the bloodbath of the Greek Debt Crisis on May 5th.

    So, dear reader, maintain a death-grip upon the obvious: watch the price chart of the instrument you actually trade.

  • Jez

    “test what you trade and trade what you test”
    That could have been a conclusion of this post indeed – thanks Pumpernickel (and for the VIX chart)

    I was actually looking at this as a counter-example to the approach I described for optimising the roll yield on a standard Trend Following strategy (post here). In the case of the Peso, the approach would probably not have worked (since most signals would likely be short ones as the cash is falling). And I’m left researching how to make the approach more clever about it (ie comparing roll yield vs spot volatility for example, or using the front-month instead of spot for signal generation, or looking at multiple contract time-series as individual traded instruments, etc.)

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