A Case For Buying VXX Puts

The major volatility events of March and June 11th have moved out of short and medium term trailing volatility windows and as yield enhancing funds prepare to collect premium, we find the term structure of VIX futures in a pre-pandemic contango and in disagreement with spot VIX. We believe that this scenario signals an impending volatility crush and we consider a risk defined strategy to profit from it with VXX puts.

Historical logscale price of VXX adjusted for splits.

Lower Realized Volatility

The pandemic-induced volatility of March has now moved out of the popular short-term and mid-term volatility windows as shown below. Consequently, programmatic quantitative risk models will start getting the green light to seek enhanced yields by selling volatility risk premiums. We believe this behavior will further compress volatility premiums in a self-reinforcing cycle.

SPX and historical volatility measures. Historical volatility is calculated for 10-day and 20-day periods with close-to-close and Yang Zhang methods.

Return of Contango

As time progresses, the VIX futures portfolio that comprises the VXX ETF is rebalanced by selling the first month future and buying the second month future. A VIX futures term structure that is in contango means that VXX will effectively have a negative "roll yield". As the contango in the VIX futures increases, the roll yield of VXX is pushed deeper into negative territory.

The figure below shows how, since mid June, the shape of the VIX future's term structure has gradually re-steepened to February levels. This presents an opportunity to capture the negative roll yield in VXX through short exposure.

The upper graph shows VIX and linearly interpolated VIX future prices for 30-day and 60-day tenures. The lower graph shows contango, which is defined as the percent difference of the 60-day interpolated VIX future versus the 30-day interpolated VIX future.

High Spot, Steep Structure

A spot VIX of 25 is unprecedented for the current degree of steepness in the VIX futures term structure. Typically, a spot VIX of 25 corresponds to an inverted (backwardated) futures curve and a contango of ~5\% corresponds with a spot VIX of 10 to 20 (Figure \ref{fig3}). While we do not think spot VIX will come in to 10 soon, we interpret this historic dynamic to mean that there is decent room for the VIX futures curve to level-shift downward while maintaining its current shape.

Scatter plot of VIX futures contango versus spot VIX. We compare data points before and after March 2020. Contango is defined as the percent difference of the 60-day interpolated VIX future versus the 30-day interpolated VIX future.

Conclusion

We believe that the best way to capitalize on these observations is through long exposure to 60-delta VXX October puts. The choice to use ITM puts provides higher short exposure to the underlying while still maintaining the strategy risk-defined. Furthermore, in contrast to typical equities, short-term rises in VXX price typically correspond to higher volatility and call-skew. This rise in volatility is expected to provide a small buffer during upward price moves.

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