Why shorting volatility during VIX futures contango may fail - Part 2

VTS Community,

* I had a very strange email yesterday from someone who thought the failed backtest I was criticizing in Monday’s article was our live results.  I’m sorry about that, I’m an investor, not a writer so perhaps I didn’t make that clear enough.  So just to be clear, these last few articles are me critiquing a commonly quoted but pretty awful volatility signal.  I’m trying to dispel a common myth here that I see quoted on Twitter so often.  I want it to stop.  There are people on Twitter with thousands of followers who give out the worst advice ever that all you have to do is short volatility during contango and money just rolls in.  I’m hoping to do some good here by crushing this ignorant advice so people don’t continue to lose money listening to them.  Don’t for a second think we actually follow these basic signals here at VTS, but back to the program.

I’ll do one more related article today and then we’ll shelf this for a little while and move on to other things.  So again if you missed it, Monday’s article is here.

VXX and why following VIX futures term structure signals may fail

In it, I showed the performance of a commonly quoted  (but awful)  simple VIX futures term structure contango following strategy and how poor of a signal it has been in the long-run.

Investors are very influenced by the recency effect so it’s not surprising that most of the follow-up questions were about 2018 and the miserable performance of that simple VIX futures strategy so far year to date.  I had quite a few direct messages on Twitter saying wow really?  Apparently, they were told this signal works but as I’ve shown, obviously it doesn’t.  Something that people asked a lot was:

“What about only taking the short volatility trades and ignoring the long volatility trades, would that have done any better?”

Great question!  The first thing I will say is, why would you want to do that?  I know it’s been a very long time since a significant market decline, but at some point, it’s going to happen.  Those long volatility trades may be the best defense against a market crash so I personally would never remove those from any of my volatility strategies.  We don’t take long volatility trades often, but they will be an important component to surviving and potentially prospering during the next market crash.

So I would never do it, but that’s the question people had so let’s examine it.  First, for comparison here’s the chart showing both short VXX and long VXX positions using 0% M2:M1 as the threshold crossover in 2018.

Both long and short volatility: Strategy (blue):  If M2 >/= M1, short VXX.  If M2 < M1, buy VXX

So this 0% M2:M1 threshold is pretty unreliable right?  Down -25.16% year to date so the question is, would only taking the short volatility trades have improved things?  Well, I can easily dive into my spreadsheet and run those numbers.

Short volatility only: Strategy (blue):  If M2 >/= M1, short VXX.  If M2 < M1, Cash

The performance of only taking the short VXX trades year to date is -19.96%, so roughly a 5% improvement on the original long/short signal.

And if you’re curious about the dates and prices of those trades, there would only have been 9 changes of position so it’s pretty easy to track.  Now I definitely do not recommend people do these backtests longhand like I’m about to show below, but this is just for illustration.  The chart style above is actually extremely easy to do in an Excel spreadsheet and should only take about 10 minutes so please save yourself some time and just do it that way.  In a future video, I will show everybody how to do these simple backtests in Excel.  (spoiler, it’s easier than you think)

The only real difference was the long volatility trades benefited greatly from the volatility spike on Feb 5th, but then gave back all of those gains in the subsequent few months.  Leaving them out would have been a little smoother, but then again this is only 20/20 hindsight.

What if Feb 5th was the start of a larger crash than we actually saw?  If that happened, the long/short strategy may have been far better.  So again I personally have long volatility signals in all of my strategies.  I haven’t taken any in a while, but they are there to protect against major market declines.

Bottom line, these simple strategies were just about equally terrible and the main point remains the same.  Blindly following the VIX futures term structure and shorting volatility when in contango and going long volatility when in backwardation has not worked since 2012.  A fund tracking that would be at the same value today with no gains nearly six years later.

And I don’t mean any disrespect when I ask this but honestly, why would anybody expect that “strategy” would work?

How bizarre would it be if all a person had to do to succeed in trading was to log on to VIXcentral.com, look at one single percentage value, and successfully make money?  How crazy would that be?  I know there are people on Twitter who think they are saying something profound to quote “the VIX board” every day but come on.  A 10 minute backtest shows how brutal the drawdowns would have been following that.

Unfortunately, investing is substantially more difficult than that and the options and futures markets are way too efficient to allow for such a basic signal to work.  It’s a very safe bet that any periods of gains following basic signals will be given up, and the long-term expected rate of return will be very low.  That’s exactly what this terrible backtest shows.  Despite some periods of good performance, for six years it went up, it went down, yet there it is right back to break even.  Perfectly in line with our rational expectations.

There is no free lunch in investing!