Author: Robert Zingale
Covestor model: Volatility Mean Reversion
Disclosure: Short VXX
With many news stories giving investors anxiety in May, contango on VIX futures held at its 2011 year-to-date average throughout most of May (as calculated by the difference in settlement prices between the current and next month’s VIX futures contract on the same closing day). VXX fell in May, which was mainly attributable to contango, as VIX volatility futures closed flat.
VIX Index Forecast
VIX futures are pricing an increase in the VIX index, however, the VIX futures term structure has been upward sloping for most of 2011, and we have not seen too many large jumps in volatility (except for the Japan earthquake). Although the market has been consistently declining, investors don’t appear to be hedging large drops in the market, which is suppressing the VIX index whose value is derived from the implied volatility from options on the S&P 500. However, if losses continue to accumulate such that the S&P 500 becomes negative year-to-date, investors will likely become increasingly uneasy, making protective puts more attractive to save any portfolio gains.
Based on the VIX futures term structure and current market conditions, I am expecting a moderate increase in the VIX to levels between 20-24, with the possibility of a large spike.
VXX Forecast
VXX contango has been consistently high in 2011 since the VIX index has remained at or below its long-term mean-reverting level for most of 2011. VIX futures traders price the higher VIX expectations into their quotes to be compensated for the higher statistical chance of an increase in the VIX. Since the extent of contango is dependent on the level of the VIX index and expectations of higher VIX levels, it is difficult to forecast the rate of contango for the coming month. If the VIX remains below 22, I would expect the level of contango to average around 7-9%. However, if a large spike in volatility occurs, this could greatly reduce the yield from contango.
Based on my contango and VIX index expectations, VXX is likely to be flat or slightly higher in June.
Current Position Rationale
I will maintain my current ~20% short position against the VXX (VXX + XIV), given the current contango of the VIX futures. I have no immediate plans to add any more short exposure because price risk of the VXX is high given future VIX expectations in the market. However, if the VIX index goes above 25, I will double my exposure to 40% in order to average my price entry points on the VIX. My additional 20% exposure should benefit from a decrease in VIX price as it reverts back down to its mean-reverting level and from likely future contango (VIX futures have historically been in contango, and I do not foresee a structural change that would change this characteristic).
Sources:
VIX performance from CBOE, http://cfe.cboe.com/Products/historicalVIX.aspx
