Strategy #1 for Trading Volatility ETPs: Term-Structure Following
In my previous post I talked conceptually about 2 strategies I use for trading volatility ETPs like VXX and XIV. In this post I’d like to drill down on the first of those strategies: following the VIX futures term-structure.
As the chart below shows, most of the time the term-structure acts as a strong tailwind in favor of either trading short volatility (ex. short VXX/long XIV) or long.
The chart shows my estimate of the average daily impact that the VIX futures term-structure had on VXX over the previous 63-days (3 months). You can more or less flip these results for XIV.
For example, if the chart reads +0.5%, that means the term-structure boosted VXX (regardless of changes in the VIX) by 0.5% per day over that 3 months (or about 251% annualized).
Geek note: I’m using “term-structure” loosely to mean roll yield, time decay, and all other factors not directly related to immediate changes in the VIX itself.
I don’t want to share the math on this one because I think this is one of the competitive advantages of my model, but you could get in the ballpark simply comparing the first/second month futures contracts.
Keeping it really simple, let’s assume we bought VXX at the close when the values in the chart above were positive, and bought XIV when the values in the chart were negative. This is just a proof of concept, so I’m ignoring transaction costs/slippage.
This strategy is overly simple, but would still have put up impressive numbers: a 57% annualized return with only 8 trades per year, since 06/2004.
There’s clearly some low hanging fruit to improve results (like stop losses), but I think it proves the point nicely that simply following the VIX futures term-structure, and ignoring what’s happening with the underlying VIX, is a workable strategy.
As I mentioned in my last post, in my own trading I mix a term-structure following approach with one timing the underlying VIX itself.
More on this more advanced strategy in a future post.
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Filed under: Trading Strategies, VIX & Volatility | 10 Comments