Exploiting Term Structure of VIX Futures

Volatility trading has become very popular since the financial crisis in 2008 as investors started to appreciate volatility’s negative correlation to common equity/commodity markets. It is, therefore, understandable that there is an increased interest in strategies that utilize the volatility premium.

The easiest way to access this market is via liquid VIX futures contracts; however, there have not been a lot of academic research papers focused on this area. Luckily one recent research paper has come up with a strategy exploiting the volatility premium via VIX futures with really promising results.

Fundamental reason

Academic research states that volatility follows a mean-reverting process, which implies that the basis reflects the risk-neutral expected path of volatility. When the VIX futures curve is upward sloped (in contango), the VIX is expected to rise because it is low relative to long-run levels, as reflected by higher VIX futures prices. Likewise, when the VIX futures curve is inverted (in backwardation), the VIX is expected to fall because it is above its long-run levels, as reflected by lower VIX futures prices.

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Markets Traded
equities

Backtest period from source paper
2007-2011

Confidence in anomaly's validity
Moderately Strong

Indicative Performance
19.67%

Notes to Confidence in Anomaly's Validity

OOS back-test shows slightly negative performance. It looks, that strategy’s alpha is deteriorating in the out-of-sample period.


Notes to Indicative Performance

per annum, based on cumulative 5-year gain from backtest stated on the page 18 (82 000$), calculated for starting account size 5-times the initial margin (56 375$)


Period of Rebalancing
Daily

Estimated Volatility
0%

Notes to Period of Rebalancing

Notes to Estimated Volatility

not stated


Number of Traded Instruments
2

Maximum Drawdown
0%

Notes to Number of Traded Instruments

Notes to Maximum drawdown

not stated


Complexity Evaluation
Complex strategy

Sharpe Ratio
0

Notes to Complexity Evaluation

Region
United States

Financial instruments
futures

Simple trading strategy

The trading strategy is using VIX futures as a trading vehicle and S&P mini for hedging purposes. The investor sells (buys) the nearest VIX futures with at least ten trading days to maturity when it is in contango (backwardation) with a daily roll greater than 0.10 (less than -0.10) points and holds it for five trading days, hedged against changes in the level of spot VIX by (long) short positions in E-mini S&P 500 futures. The daily roll is defined as the difference between the front VIX futures price and the VIX, divided by the number of business days until the VIX futures contract settles, and measures potential profits assuming that the basis declines linearly until settlement. The hedge ratios are constructed from regressions of VIX futures price changes on a constant and on contemporaneous percentage changes of the front mini-S&P 500 futures contract both alone and multiplied by the number of days to the settlement of the VIX futures contract (see equation 3 on page 12).

Hedge for stocks during bear markets

Partially - Half of the strategy which buys VIX futures can be used as a hedge against equity market crises. The other half is a short volatility strategy and therefore is absolutely not suitable as a hedge …

Source paper
Out-of-sample strategy's implementation/validation in QuantConnect's framework (chart+statistics+code)
Other papers

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