VXX trading based on fundamentals

In a previous article we have presented a simple option strategy that can be put in place to capture the expected erosion of contracts like VXX or VIXY.

Just as a recap, in that article we have said that is wrong to believe that the daily rolling of VIX futures during contango, 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 (or VIXY). Instead, the erosion is coming from the contango itself, not the daily rolling. After all, by holding a unit of VXX/VIXY 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. So contango is the source of price erosion for these VIX-related instruments.

We also said that 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.

The strategy we presented was a simple unbalanced (or broken wings) condor with a max profit zone located where we expect the underlying to be by the time the options expire, with no risk on the upside and a defined risk on the downside.

In this article we want to look at this in more detail to get an idea of where the max profit zone needs to be set and how likely it is for our max risk to be hit by the VXX movement.

The strategy

Let’s start by showing the strategy on August’s monthly expiry. With almost 75 days till expiry, we have created a max profit zone that, at current levels, would cover a VXX movement from -3% to -29%. In other words, if VXX will decline between 3% to 29% the strategy will make the highest profit (in this case $123). The lower breakeven point is distant 30% and we will have the largest loss (in this case $277) if VXX declines more than 34% by August 20. As you can see, the strategy is fully hedged against spikes in VIX futures and will actually make some money even if VXX will rise.

The plots below are showing the strategy P&L profile at different point in time (i.e. today, in 45 days and in 60 days).

Needless to say that with options there are many possible alternative combinations and one could prefer to have no profit or even a small loss on the upside, in return for a higher max profit zone and/or lower max risk. An example below where we added a small put debit spread to the previous strategy to lower our max risk and change the max profit zone (sacrificing profit potential on the upside).

But let’s go with our first choice. Focusing on the red curve, we can see that delta is positive so an immediate rise in VIX futures would be beneficial. As time passes, and the VXX starts to erode, the startegy should have a positive P&L (depending on how low VXX has moved) and could be closed before expiry if needed. The only real risk is a sudden and drastic drop in VXX.

To understand if we can be comfortable with this profile it is worth looking at what has been the behaviour of VXX/VIXY over the following 75 days in the past.

Just looking at the expected erosion might give us an under estimation of the movement we can observe in the underlying. We can expect the underlying to decline at a faster rate due to many reasons. One could be the VIX level itself. While it is true that trading VXX/VIXY we are trading the expectation of where the VIX will settle on the expiry date of the contract (i.e. not the VIX index itself), we can see if the VXX/VIXY 75 days forward returns are somehow affected by where the VIX index currently is.

The plot below shows the median return in dark grey, while the shaded area corresponds to the range between the 25th and 75th percentile.

So, given that currently VIX is between 15 and 20 we can say that historically 75% of the time the return over the following 75 days has been higher than -35%, and 50% of the time it has been higher than -25%. Our max profit zone is currently set to include most of this range.

Before concluding that we are comfortable with this payoff, we can also look at a lower quantile. The plot below tells us that at current VIX levels (between 15 and 20), we observed a 75 days forward return higher than -41% for 90% of the time.

And our max risk area that is distant 34% would have not been reached 80% of the time, as per plot below.

 

We can also look at a different dimension. The ratio VIX/VXV gives us some information about the slope of the VIX term structure. In fact, while the VIX index represents the current market expectation about the volatility of the S&P 500 index over the next 30 days, VXV is a measure of expected volatility over 3 months.

Currently this ratio is below 1 and that is the usual configuration that we see most of the time (i.e. contango).

The median 75 days return when VIX/VXV is below 1 is -25% and 75% of the time the return is above -35%. The plot below shows that in contango the 75 days return is higher than -41% on 90% of cases.

 

Returns before expiry

So far we looked at the 75 days return given that the strategy expires in that timeframe. But it is also interesting to look at returns on intermediate timeframes to see how likely is for us to close the strategy at a profit before expiry.

In the charts showing the strategy (see previous section), we also display the P&L profile that we can expect in 45 and 65 days. So let’s look at the returns over these periods.

In 45 days we can expect the strategy to be in profit if the underlying has dropped less than 18%. Please note, we ignore here the impact of implied volatility but since vega is negative, any decrease in implied volatility would be beneficial, while sudden increases would hurt the P&L. Typically, VXX implied volatilities increase when VXX increases so we can expect that as VXX declines our negative vega could potentially add to the profits, although at a lower rate given our negative vega will also reduce at lower VXX levels.

From the chart below, we can see that if the strategy is initiated when VIX is lower than 20 it is more likely to see the strategy in profit already after 45 days. If the strategy is opened with VIX at higher levels, the median 45 days return is lower than -18% and the expected P&L would typically be negative (with the only exception of the range 30-55).

In 60 days we can expect the strategy to be in profit if the underlying has dropped less than 26%, again ignoring the impact of implied volatility.

Even in this case, if the strategy is initiated when VIX is lower than 20 it is more likely to see the strategy in profit before expiry. If the strategy is opened with VIX at higher levels, the median 60 days return is lower than -26% and the expected P&L would be negative.

 

The trading plan

The rationale of this strategy is based on the fundamentals of the VIX futures markets and their impact on the price of VXX/VIXY. A trader could start opening a strategy expiring in 2/3 months and then repeat that (likely on different strikes) for any subsequent month, so that in 2/3 months there will be a strategy expiring every month.

A way to potentially improve the payoff (i.e. reducing the max risk and/or enlarging the profit zone) is to build the strategy in more steps.

The simplest way to do so is by looking at the unbalanced condor as the combination of one bullish credit spread and one bearish debit spread. Indeed, the strategy is nothing more than a put bear spread funded by a 2x put credit spread.

Since Trading Mate actively trades SVXY/VXX (see all results here), one could use this system to decide which spread to open first. Please remember that while SVXY is our trading vehicle, similar results could be achieved by using VXX in the opposite direction, but remembering that SVXY is actually now trading at 0.5X leverage. So, results below show that the system could be used not only for directional trading in VXX or SVXY but also to assist in the building of our option strategy.

If Trading Mate’s signal on SVXY is short (hence long on VXX), one could start opening the bullish credit spread and wait for a flat or short VXX signal to add the bearish debit spread to complete the strategy.

By actively timing the entry, one could significantly improve the risk/reward of the strategy. Once the strategy is completed, one simply waits for the VXX erosion to run its course and hopefully reach the profit zone.

 

Conclusions

The startegy we have discussed has the potential to benefit from the VXX price erosion due to contango without exposing the trader to significant risks that, in the field of volatility, are typically on the upside.

This strategy can be structured to have a max profit that is at least 40% of the max risk, with a profit zone that covers a significant drop in the underlying.

Historical data suggests that the choice of the strikes (that will ultimately determine the profit zone) depends to some extent on the VIX level. With VIX lower than 20 it is likely that the strategy can be closed at a profit even before expiry.

Luckily VIX is lower than 20 at least 75% of the time so the best conditions to open this stategy can be met quite frequently.

While all these conditions can help setting up a strategy with higher chances of profit, opening the strategy in two moves by following Trading Mate’s signals could significantly improve the P&L profile.

Here you have it: a quantitative trading strategy to help you setting up a strategy to profit from the fundamental dynamics of VIX future markets.

Access the updated portfolio here