Timing VIX Futures with the Futures-Spot Ratio

Is the return on CBOE S&P 500 Volatility Index (VIX) futures predictable? In his preliminary paper entitled “The Expected Return of Fear”, Ing-Haw Cheng investigates whether the relationship between VIX futures prices and VIX level predicts the return on VIX futures. He focuses on monthly returns to a continuously-invested position in the nearest available VIX futures contract. He considers several different explanations for the behavior of VIX futures prices. Using VIX futures daily settlement prices during March 2004 through July 2014 (125 months), he finds that:

• The average level of VIX over the sample period is 19.9%, compared to 16.2% for the annualized realized volatility of the S&P 500 Index over the next 30 days. The average annualized volatility of VIX (VVIX) is 84% over this period.
• On average over the sample period, VIX futures prices are higher than VIX and exhibit muted reaction to changes in VIX (1% increase in VIX relates to 0.65% increase in the nearest futures contract price).
• Over the sample period, a continuous long position in the nearest VIX futures contract:
  • Has an average maturity 34 days.
  • Exhibits a market beta of about -3.
  • Generates a gross monthly excess (relative to the risk-free rate) return of -4% with monthly volatility 16.7% and gross monthly Sharpe ratio -0.23.
  • Generates, however, a non-negative gross average return over the month after instances of backwardation (peaks of crises, when VIX exceeds VIX futures prices).
• The ratio of VIX futures price to VIX level relates negatively to next-month VIX futures return with an R-squared statistic of 0.16, indicating that the ratio explains 16% of the variation in return.
• A simple trading strategy which each month sells nearest-term VIX futures (holds cash) when the ratio of VIX futures price to VIX level is greater than one (not greater than one) generates a gross average monthly excess return of 4.3% with monthly volatility 11.9% and gross monthly Sharpe ratio 0.36.
• The relationship between VIX futures price and VIX level does not predict U.S. stock market returns.

In summary, evidence indicates that investors may be able to time a short position in VIX futures according to the ratio of VIX futures price to VIX level, exiting when the ratio is less than or equal to one.

Cautions regarding findings include:

• Reported performance is gross, not net. Accounting for trading frictions from entering and exiting contracts approximately monthly would reduce returns.
• Exiting short positions during crises may incur exceptionally high frictions.
• The high volatility of the timing strategy suggests large drawdowns.
• Return on investment calculations would have to account for cash reserves required for any margin calls that may occur during intra-month drawdowns. 

For implementations of this timing strategy with exchange-traded notes (ETN), see “Exploiting VIX Futures Roll Return with ETNs” and the Roll Yield trading strategy in “Volatility Trading Strategies”.

Frequently Asked Questions

What is the VIX futures-spot ratio and what does it mean in investing?

The VIX futures-spot ratio is the price of the nearest VIX futures contract divided by the current VIX level. A ratio above one means futures trade above VIX (contango), while a ratio below one means VIX exceeds futures prices (backwardation), which typically occurs at the peaks of crises. Over March 2004 through July 2014, VIX futures prices were on average higher than VIX.

Does the VIX futures-spot ratio predict VIX futures returns?

The VIX futures-spot ratio relates negatively to next-month VIX futures returns, with an R-squared of 0.16, meaning it explains about 16% of the variation in return. A strategy that sold nearest-term VIX futures when the ratio exceeded one and held cash otherwise generated a gross average monthly excess return of 4.3% (Sharpe ratio 0.36) from March 2004 through July 2014. The ratio did not predict U.S. stock market returns.

How is a VIX futures timing strategy based on the futures-spot ratio constructed and tested?

The VIX futures timing strategy each month compares the nearest VIX futures price to the VIX level, selling nearest-term futures if the ratio is greater than one and holding cash otherwise. It was tested on monthly returns to a continuously invested position in the nearest VIX futures contract, using daily settlement prices over 125 months from March 2004 through July 2014. The strategy produced monthly volatility of 11.9%.

How does the VIX futures timing strategy compare to simply holding a long VIX futures position?

The VIX futures timing strategy far outperformed a continuous long position in the nearest VIX futures contract over March 2004 through July 2014. The long position had a gross monthly excess return of -4%, monthly volatility of 16.7%, Sharpe ratio of -0.23, and a market beta of about -3. The timing strategy delivered a 4.3% gross monthly excess return with 11.9% volatility and a Sharpe ratio of 0.36.

What are the risks and limitations of timing VIX futures with the futures-spot ratio?

The reported VIX futures timing results are gross, not net, so trading frictions from entering and exiting contracts roughly monthly would reduce returns. Exiting short positions during crises may incur exceptionally high frictions. The strategy's high volatility suggests large drawdowns, and return calculations would need to account for cash reserves required for margin calls during intra-month drawdowns.