Profiting from VIX futures contango with low risk VXX and VIXY options strategies – theory and practice

The VIX index represents the current market expectation about the volatility of the S&P 500 index over the next 30 days. Being a volatility measure, there are features like volatility clustering and mean reversion that make VIX index relatively easy to predict. Volatility clustering means that high volatility tends to be followed by high volatility, hence creating a cluster of high volatility. But over a relatively longer period of time, volatility tends to revert towards a long term average level.

The fact that VIX index is relatively easy to predict might sound very promising but, unfortunately, it is not possible to trade the VIX index directly. The market offers instruments like VIX futures and options that can be used to express our view on the VIX index but by trading them we are actually trading the market expectation about where the VIX index will settle on the expiry date of the contract.

Making profits with VIX futures requires different set of strategies like the ones we use in our portfolio, so if interested you can access them below.

Access the updated portfolio

The results we obtain with such strategy can be seen below. Here we indirectly trade VIX futures by using SVXY, but similar results would be obtained by taking the opposite position on VXX or VIXY.

 

So we can successfully trade VIX futures (or related instruments like SVXY) but in this article, instead, we want to trade based on the fundamentals of the VIX market. Let’s focus on VIX futures. These contracts are already pricing the expected value that the VIX index will have when the contract expires. Even if the VIX index is easy to predict, that prediction is essentially already priced in the future price. The consequence is that predicting the VIX future prices is not as simple as predicting the VIX index.

There are other VIX-related instruments that retail traders might be more familiar with as they belong to the family of ETF/ETN. Popular examples are those we use in our trading portfolio mentioned above, like VXX, VIXY, SVXY, etc. All these instruments can be seen as portfolios of VIX futures so all we said for VIX futures is valid here.

This article will focus on VXX because of its high liquidity and characteristics that make it an interesting instrument to trade.

For those who are not familiar with this instrument, it is sufficient to know that it is a product that holds a daily rolling position of the first two monthly VIX futures. Every day, in order to maintain a 30 days exposure, the note will sell some units of the first month contract and buy some units of the second month contract.

One critical aspect to notice is that VIX futures are in contango most of the time. Under this configuration, futures that are closer to expire are trading at lower prices than contracts with longer expiries, i.e. the future curve is upward sloping.

Even if contango is the most common shape, VIX futures will sometimes be in backwardation. When this happens, we see future prices that are close to maturity trading at higher prices compared to longer term contracts, i.e. the curve is downward sloping.

Two examples are show below. The spot VIX is shown as red point, while the first 2 monthly contracts that are used by VXX are shown in green.

 

Clearly, in contango the future that is the closest to maturity (M1) trades at lower price compared to longer maturities (for example the second month, M2). The opposite is true when the curve is in backwardation.

It is a common belief that, during contango, the VXX daily rolling consisting in selling the front contract at lower price and buying the second month at higher price is the reason for the price erosion that we observe in VXX.

The truth is that the erosion is coming from the contango itself, not the daily rolling. After all, by holding a unit of VXX we are investing in a portfolio of long VIX futures and in contango these futures are “rolling down the curve” to settle at the spot VIX level on expiry date.

This is evident if we look at it in a static way. If VIX spot is not moving until M1 future expires, this future will eventually go down to converge to the spot value on expiry date. Given that VXX hold a quantity of this future, its value will go down accordingly. The same process is valid for M2.

So we know two things:

• VIX futures are in contango most of the time
• Contango is the source of erosion in VXX

Many investors generate regular returns by selling VXX to capture this price erosion. But shorting this contract can be extremely dangerous since VIX index might move up significantly driving up also the VIX term structure and hence the VXX.

If you look at the previous chart, it could easily be that we moved from the blue curve to the black curve in a matter of days. If that’s the case, a short VXX exposure that was held to capture the regular erosion due to contango will suffer significant losses.

So even if contango is eroding the VXX value, the VIX index might move significantly while a trader is trying to capture this price erosion. When the spot VIX moves, the futures will move as well (even if to a lesser extent) and a sustained rise in the spot price might lead to backwardation. When the curve is inverted, also the eroding forces we saw earlier during contango are inverted and contributing to VXX rising further even if spot VIX stays flat at that higher level for a while.

So harvesting the VXX erosion by simply shorting the VXX is not a safe game. A safer way to capture VXX erosion due to contango can be obtained by using VXX options.

One of the simplest strategies one could put in place is a broken wing condor or a broken wing butterfly. Possible strategies are shown below.

 

While the green one is a broken wing butterfly, the other two are broken wing condors. Let’s say we want to use the blue strategy. Assume VXX is trading at 20, the unbalanced condor in blue could be obtained by:

• Buying 2 puts strike 12 maturing in 75 days
• Selling 2 puts strike 15 maturing in 75 days
• Selling 1 put strike 17 maturing in 75 days
• Buying 1 put strike 20 maturing in 75 days

So, essentially we are buying a put bear spread (strikes 17 and 20) funded by a 2x put credit spread (strikes 12 and 15).

Most of the risk is on the downside so this position should not be taken when we expect VIX index to drop significantly. But this strategy is well positioned to benefit from the normal price erosion in VXX due to contango. This erosion is not fixed and can change depending on the VIX term structure but on average it is expected to be between 5% and 8% monthly. So there are few important points that we need to remember:

• We want to capture the price erosion in VXX due to contango
• We want to be hedged against possible spikes in VIX
• We want our profit zone to be the highest in the price region where we expect the VXX to be (by the time options expire) due to erosion

 

 

The unbalanced condor above is ticking all the boxes as by the time the options expire we expect the erosion to have driven the VXX price down by more than 15%.

During the life of the trade the VXX price will move driven by changes in the VIX term structures but we have hedged our risks on the upside and the only real risk is that VXX will move down more than what we expected due to erosion. Since this is certainly possible, it is important to leave a bit of buffer to accommodate a higher drop maybe due to an unanticipated decrease in VIX.

The chart below shows our P&L profile after 45 days in the trade.

 

Greeks profiles at two different point in time can be seen below.

 

So this is a low-risk strategy to profit from the typical shape of the VIX term structure and its impact on price erosion of VXX. The strategy can be put in place in one time or the trader can first add one spread and then the other. So, in the example above, if there is a long signal on VXX it is better to start with the put credit spread and then add the put bear spread once there is the short (or flat) signal. For more guidance in terms of expected direction you can access our updated portfolio page below. 

Access the updated portfolio