We have previously found that it is difficult to trade the VIX futures (/VX) and consistently be profitable. This made us wonder if there was any way to use the basis in order to formulate a viable trading strategy.
Today, Tom Sosnoff and Tony Battista attempt to find out if you can use the basis of the front 2 /VX contracts to formulate a trade. The basis between the two contracts is found by subtracting the price of the further dated future from the price of the closer (front month) future. If this value is negative, the curve is in Contango. If it is positive, the curve is in Backwardation.
After the guys find out the average values of the curve in Contango and Backwardation, the look to test a simple calendar spread using the futures. When the curve is in Contango they bought the cheaper front month and sold the more expensive back month. However, this was not profitable no matter how extreme the curve was.
Next, they looked at the opposite trade. When the curve was in Backwardation, they sold the more expensive front month and bought the cheaper back month. Here they found that the only way this was profitable was if the spread was backwardated to 2 standard deviations.
Finally since we know that VXX has a drag when the curve is in contango, we wanted to see if it could be used as a hedging vehicle when the curve is in Backwardation. To test this, the guys got long VXX whenever the curve was +1.0. They found out that using this strategy return 24% over the last 4 years!
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