Wednesday, July 15, 2015

VIX contango magic explained

A good question: why VIX futures are in contango most of the time? The same question, but differently formulated: why VXX shows a downtrend most of the time?

That happens because traders expect the options IV (which is VIX) to return to an average market level of 19 faster than they should. Most of the time option market show IV less that 19. This average level number is mostly influenced by high volatility periods around 2000 and 2008 downside markets. Today's market is much more calm. But VIX futures traders anyway price a fast return of VIX back to the mean levels.

That's why when markets are calm, this VIX futures contango drives VIX ETFs like VXX, VXZ down and reverted ETFs like XIV, ZIV up. But what's important, this calm markets also happen when S&P 500 grow. This is called "leverage effect". The name is a bit confusing because really there's nothing about a leverage here. The guy who's called this effect "a leverage effect" probably regrets is by now. Anyway, this effect means that when markets are calm, they tend to grow. And this effect is very strong on stock indexes like S&P 500.

So, when volatility is down, S&P 500 grows, VIX contango is on, VXX falls. When volatility is up, S&P 500 crashes, VIX contango turns to zero or even into backwardation, VXX surges.

This all makes VXX look a bit like reverted SPY. And this is a very strong comparison, because if you compare SPY and reverted VXX in risk-adjusted scale, there's really not much difference. There's no point in shorting VXX or shorting VIX futures all the time because all you will get you can get by having a long position on S&P 500 directly. And I can even tell you the leverage number: it's about 4x.

Compare XIV (VXX reverted) and 3-x leveraged S&P 500 SPXL:



As you can see, there's not much difference.

So the answer on the initial question is this: VXX falls most of the time because S&P 500 grows most of the time. No place for magic, sorry.

No comments:

Post a Comment