EC Strategies For Trading Inverse Volatility

The Basic "Contango Rule" Strategy for VIX

For this strategy, all you have to do a daily check of the VIX term curve. 

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As long as the front month is in contango (curve goes up from left to right), such as in the chart above, you can go short VXX or long XIV. Sometimes you will see the front part of the curve go up until the front month goes to backwardation.

Here in this graph, you see the days of the last fiscal cliff fear spike.

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If the two front months of the VIX term curve are in backwardation and the curve drops downwards, such as in the chart above on October 7-8, this is a clear sign to exit VXX or XIV. From October 10, the curve returned to contango and you could have again shorted VXX or gone long XIV.

It is clear that most of the time when you have to exit it is because of a short VIX fear spike (such as above) which is over after a few days. You will have to realize a loss, but, this is inconsequential. Normally, you need only a few days to cover these losses again as the normal VIX contango situation is restored. In the example above, the front month future was below 20, which is not that worrying, but in 2008, this value spiked to 70. This means that going short VXX would have meant the possibility of realizing 300% losses if you didn't strictly follow any exit rules.

This "contango rule" strategy is not really a strategy, because it doesn't give you a clear exit signal, however, if you invest in inverse volatility, you MUST know the VIX Futures term structure.

The Bollinger Band or Simple Moving Average Strategy

These are strategies which work well and which have the advantage that you can backtest the strategies, or you can even automate these strategies. I used to trade the Bollinger band strategy for quite some time automatically with Tradestation.

Here is the backtest of this strategy since Feb. 1, 2009, which was when the VXX started. The performance has delivered a 96.41% annualized return or 2370% in total if you reinvested all profits. If you invest always the same amount which is what I did, then you get 5.8% per month which is a very nice monthly income.

The SPY ETF has delivered only a 20% annualized return or 137% total return during the same period. This is also very good but pales in comparison to the VXX strategy return.

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The maximum drawdown of this strategy was 27.7% compared to 20% for the SPY ETF. The risk to return ratio of such a strategy is 3.27 compared to 0.99 for the SPY ETF. So, even if trading VXX is considered risky, with the right strategy you could have had a 3x better risk to return ratio than for the US equity investment (SPY).

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