The behavior of the VIX is a lot more predictable than something like a stock. It tends to hang out at a certain level, and occasionally spike. If you could trade it directly, this suggests a simple strategy: Buy when it’s steady, and then sell when it spikes. Even if you can’t time the spikes perfectly, you’ll make a lot of money.
So can you do this with the futures? No, because someone has to take the other side of the trade, and they know it might spike, so they’ll price that in! It’s like buying insurance. You have to pay a “risk premium” to the market to hold a long vol position. If you plot a logrithmic chart of an ETF that tracks VIX futures, like VIXY, you’ll see that there are frequent sharp payouts for the spikes, but over the long term, the trend is pretty steeply negative. Plot that on the same graph as the VIX, and you’ll understand why we say you can’t trade the VIX. Unless you can predict the spikes pretty well, you’d be better off taking the opposite trade (like SVXY) to collect that premium yourself, though it would have to be leveraged down. During the quiet periods, VIXY will cost you the premium, because it’s the wrong side of risk.
If you could trade it directly, this suggests a simple strategy: Buy when it’s steady, and then sell when it spikes. Even if you can’t time the spikes perfectly, you’ll make a lot of money.
So can you do this with the futures? No, because someone has to take the other side of the trade, and they know it might spike, so they’ll price that in! It’s like buying insurance. You have to pay a “risk premium” to the market to hold a long vol position.
It’s actually more subtle than this. There are two things going on (which I believe you understand based on “Wrong side of risk”) but you have conflated here:
The VIX exhibits behaviour whereby there are strategies where if you could trade it you could guarantee a profit: “Buy when it’s steady, and then sell when it spikes”
“You have to pay a “risk premium” to the market to hold a long vol position”
The reason you have to pay a “risk premium” to hold a long vol position is because the “spikes” are negatively correlated to the market portfolio / other assets / the economy. This means that if the expected value for holding a long vol position was zero (or positive) you could improve your portfolio risk-adjusted returns (and hence by leverage total returns) by simply adding a “long vol” position to your portfolio. Another way of saying this is “You are only compensated (positive return) for systemic risks, and long vol as is inversely correlated to systemic risk so must have a negative return”.
If there was an analogous index where the spikes weren’t uncorrelated to the broader market, the futures would still have some term structure such that you couldn’t exploit future spikes and expect to make money. However, you wouldn’t see the long term decay you see looking at (long) VIX ETFs that you do now.
Unless you can predict the spikes pretty well, you’d be better off taking the opposite trade (like SVXY) to collect that premium yourself
As I’ve said elsewhere, I think collecting vol risk premium is a poor strategy for retail investors. Vol risk premium should exist and adding expected negative return assets to your portfolio can enhance your returns. Equivalently, adding a positive expected return asset to your portfolio can reduce your returns. Caveat emptor
The behavior of the VIX is a lot more predictable than something like a stock. It tends to hang out at a certain level, and occasionally spike. If you could trade it directly, this suggests a simple strategy: Buy when it’s steady, and then sell when it spikes. Even if you can’t time the spikes perfectly, you’ll make a lot of money.
So can you do this with the futures? No, because someone has to take the other side of the trade, and they know it might spike, so they’ll price that in! It’s like buying insurance. You have to pay a “risk premium” to the market to hold a long vol position. If you plot a logrithmic chart of an ETF that tracks VIX futures, like VIXY, you’ll see that there are frequent sharp payouts for the spikes, but over the long term, the trend is pretty steeply negative. Plot that on the same graph as the VIX, and you’ll understand why we say you can’t trade the VIX. Unless you can predict the spikes pretty well, you’d be better off taking the opposite trade (like SVXY) to collect that premium yourself, though it would have to be leveraged down. During the quiet periods, VIXY will cost you the premium, because it’s the wrong side of risk.
It’s actually more subtle than this. There are two things going on (which I believe you understand based on “Wrong side of risk”) but you have conflated here:
The VIX exhibits behaviour whereby there are strategies where if you could trade it you could guarantee a profit: “Buy when it’s steady, and then sell when it spikes”
“You have to pay a “risk premium” to the market to hold a long vol position”
The reason you have to pay a “risk premium” to hold a long vol position is because the “spikes” are negatively correlated to the market portfolio / other assets / the economy. This means that if the expected value for holding a long vol position was zero (or positive) you could improve your portfolio risk-adjusted returns (and hence by leverage total returns) by simply adding a “long vol” position to your portfolio. Another way of saying this is “You are only compensated (positive return) for systemic risks, and long vol as is inversely correlated to systemic risk so must have a negative return”.
If there was an analogous index where the spikes weren’t uncorrelated to the broader market, the futures would still have some term structure such that you couldn’t exploit future spikes and expect to make money. However, you wouldn’t see the long term decay you see looking at (long) VIX ETFs that you do now.
As I’ve said elsewhere, I think collecting vol risk premium is a poor strategy for retail investors. Vol risk premium should exist and adding expected negative return assets to your portfolio can enhance your returns. Equivalently, adding a positive expected return asset to your portfolio can reduce your returns. Caveat emptor
Thank you.
I had already noticed this and wondered where the catch is.