Stock Market Returns Based on the State of the VIX Futures Term-Structure

26Feb13

A reader asked an interesting question: what does the VIX futures term-structure (contango versus backwardation) say about future stock market returns?

My off-the-cuff answer was that the VIX term-structure is only predictive for volatility ETFs like VXX or XIV (because of the impact of the underlying VIX futures converging to the VIX spot), and that it probably isn’t predictive for the stock market itself.

But I had never given the question much thought and felt it deserved some ink.

20130226.01
[logarithmically-scaled, growth of $1, frictionless]

The graph above shows the result of buying SPY at today’s close when VIX futures will end the day backwardated (month 1 > month 2) in grey, or contangoed (month 1 < month 2) in red, since 03/2004. Trades are held until a switch in the term-structure.

Numbers for the number lovers…

20130226.02

Based on the limited data available, the state of the VIX term-structure hasn’t been consistently predictive of future stock market returns. The market has been very bullish even when backwardated (see 2007/08), and very bearish even when contangoed (also see 2007/08).

The only observation that has been consistent is that future SPY returns when VIX futures are backwardated have been significantly more volatile. This should make sense given that backwardation is usually the result of market volatility/crises.

In short, my off-the-cuff response was confirmed.

. . . . .

An interesting side note.

Recall my previous post showing the results of a common strategy trading VXX/XIV by blindly following the VIX futures term-structure (long VXX when backwardated, long XIV when contangoed). More importantly, recall the horrific 90% slide such a strategy would have suffered in 2007/08:

20121220.01
[logarithmically-scaled, growth of $1, frictionless, updated through 12/2012]

The first graph in this post illustrates why that slide occurred.

When VIX futures were contangoed (long VXX), the market steadily rose, which was bad for VXX. When futures were backwardated (long XIV), the market fell, which was bad for XIV.

That’s a nice reminder that the VIX term-structure can’t be the only consideration when buying XIV/VXX in size; beta matters. I think the fact that the blind term-structure trade has worked so well in recent years has fooled a lot of traders in to forgetting that.

Happy Trading,
ms

. . . . .

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6 Responses to “Stock Market Returns Based on the State of the VIX Futures Term-Structure”

  1. 1 Jay

    It may be helpful to do the same analysis looking only at periods where the size of contango is significant (M1 at least 1 point below M2). Periods where the difference between M1 and M2 is between +/-1 are often periods of indecision (and in the volatility trades, gives the trader almost no benefit from a roll yield in either direction).

    • 2 MarketSci

      Hello Jay – smart comment – I didn’t show it in this post for the sake of brevity, but the conclusion holds at different degrees of contango/backwardation as well. — michael

      • 3 Arnold

        “When VIX futures were contangoed (long VXX), the market steadily rose, which was bad for VXX. When futures were backwardated (long XIV), the market fell, which was bad for XIV”
        When contangoed you would want to be long XIV? But the market fell taking the correlated XIV with it? and the market rose when backwardated (long VXX) taking the VXX down? Very scary if true for the naive strategy. Question is why. This might explain why strategies opposite to term structure using VIX/VXV suggested by condor options > 1.02 buy signal did work. And I would guess now do not?
        Adaptive strategy?

  2. Curious how momentum stocks would fare when VIX is in contango and value stocks when VIX is in backwardation…

    • 5 MarketSci

      Hello Alysomji – another interesting question – not much data to consider, but on the to do list to test. michael

  3. 6 Arnold

    “When VIX futures were contangoed (long VXX), the market steadily rose, which was bad for VXX. When futures were backwardated (long XIV), the market fell, which was bad for XIV”
    When contangoed you would want to be long XIV? But the market fell taking the correlated XIV with it? and the market rose when backwardated (long VXX) taking the VXX down? Very scary if true for the naive strategy. Question is why. This might explain why strategies opposite to term structure using VIX/VXV suggested by condor options > 1.02 buy signal did work. And I would guess now do not?
    Adaptive strategy?


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