As you can see in the following chart, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has reversed almost the entire rally seen in late August with shares just a few points above the lowest levels since March.
At present, I believe that the short-term probabilities favor a bounce in the VIX in the October/November timeframe. However, I believe that material issues in its methodology means that VXX is likely headed lower in the medium to long term.
VIX Markets
At the time of writing, the VIX is currently sitting at around 27 points.
This may seem like an odd way to start off a dive into the fundamentals of the VIX market, however, the outright level of the VIX is actually fairly important in that it is correlated with future changes in the VIX.
This chart is a very high level approach to looking at the VIX and it happens to be one of my favorite methods of analysis regarding gauging probabilities of future VIX movements. The reason why I favor this chart so much is that since it is so simple, it has a very strong chance of maintaining its robust predictive edge when it comes to calling changes in the VIX.
What this chart shows is very simple, yet powerful for trading: the VIX mean reverts. In other words, using the last 27 years of data, we can say that of all of the times that the VIX was around 27, it decreased in value over the next month 73% of the time. Put simply, from an outright perspective, buying the VIX at these levels likely isn’t going to make for a sound trade – over the next month at least.
However, this doesn’t necessarily mean that I believe that individuals should blindly short the VIX. While I view the VIX as likely a bit strong at this point, historic market patterns also say that the VIX tends to rally in the October-November timeframe.
What this chart shows is a clear pattern at work in the data in which during the middle part of the fourth quarter, the VIX tends to increase in value with the odds generally showing a bounce in mid-to-late October.
And seen from another perspective, the VIX tends to be most volatile during the October/November timeframe.
By putting these two data pieces together, we can construct a statistical method of trading the VIX over the next quarter. What this data suggests is that in the short-run (less than 4 weeks), the VIX is probably going to continue falling. However, history also suggests that we’re going to see a rally in the VIX in the late October / early November timeframe. Putting these two together we can say that the data says we should have a short bias for the next 4 weeks but then the next 4 weeks will likely be bullish.
For active VXX traders, this type of playbook can give insight into how they could be trading to make their actions line up with historic statistics. However, the way I trade VXX is to hold long-term put positions on the ETN. And I use the rallies seen in VXX to add to short positions to capture the long-run returns of the product.
About VXX
The reason why I am virtually always long-term bearish VXX has to do with its methodology. VXX is tracking the S&P 500 VIX Short-Term Futures Index. If you click this link and explore its long-term returns, you’ll see a fairly shocking figure: this index has declined at an annualized rate of around 50% per year for the last decade. In other words, if you had followed this index for the last 10 years, you would only have a few pennies left for every dollar you put into the index.
The reason why this is the case has to do with a few nuances of this methodology. Before getting into the details, we can make a few high level observations, the first of which is the fact that the longer that you hold VXX, the greater you will underperform the VIX.
This chart is calculated by comparing the performance of the VIX versus VXX’s index over a certain holding period and using the last 10 years of data. As you can see, VXX tends to dramatically underperform the outright changes in the VIX with holding periods as short as a month on average lagging by 5% or more. This essentially means that if the VIX were to go nowhere during a month, then on average, you would lose 5% of your VXX holdings over that time period.
And seen from another perspective, the correlation between changes in the VIX and the changes in the index diminish the longer your holding period.
This chart is very important to internalize because it has very strong implications for trading VXX. What this chart shows is that the longer you hold VXX, the less that your returns will actually mirror changes in the VIX. In other words, if you’re in VXX for more than a few weeks, your returns will be explained by something other than the actual changes in the VIX.
This key explainer of long-run returns is called roll yield or futures convergence. Futures convergence is what you get when you’re holding futures priced differently than the spot market and the differential evaporates at some time before expiry. This means that if you’re in a market in which futures are above the spot market, then you will tend to see losses from convergence because futures are above spot and converging towards spot by declining in value.
In the case of VIX futures, they have been priced above the spot level of the VIX in 85% of all days for the past decade. This means that on average, since VIX future are priced above the spot and since they are converging by declining, VXX is therefore declining in value in relation to the VIX itself. Since the VIX doesn’t really go anywhere over lengthy periods of time (stays around 15-25 for ~75% of the time), then the returns you earn in VXX are heavily dependent on futures convergence. This is why VXX has declined by around 50% per year and why it is likely going to continue to do so.
Futures convergence is the reason why I look to buy long-dated puts during pops in the VIX. The long-run numbers are fairly conclusive and show that the longer you hold VXX, the greater your losses tend to be. For this reason I add to put positions during surges in the VIX and I will be looking to add to my existing puts over the next few weeks.
Conclusion
In the short-term, VIX markets are bearish due to mean reversion; however seasonal patterns suggest a rally in October to November. The long-run returns of VXX remain strongly negative due to futures convergence which means that we should look to sell rallies in the index. The longer you hold VXX, the greater the degree to which you will underperform the VIX itself.
This article was written by
QuandaryFX
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I work within the trading and money management industry. I have been trading and investing for several years. My style is technical execution with a fundamental thesis in place. I rely heavily on statistical analysis of the correlations between fundamental changes and price movements for generating most ideas.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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