Three main sources of return when trading VIX

The return on our accounts comes primarily from three sources:

Sources of edge

01.

Volatility Risk Premium

Most researchers think that the Volatility Risk Premium is generated by the activity of investors seeking to avoid negative returns and high volatility on equity indexes. They are therefore willing to paying a premium to insure their portfolios. In practice, the premium manifests itself in the difference between the level of implied volatility of the options traded and the S&P500 realised volatility during that period.

 

Ceteris paribus, implied volatility is the level of volatility required for an option to break even. If realised volatility falls below this level, the volatility seller collects the Volatility Risk Premium.

 

As shown below, the S&P500 (represented by the SPY) realised volatility is typically lower than the implied volatility and that suggests the possibility to earn a systematic premium by selling implied volatility.

02.

Futures Risk Premium

VIX Futures Risk Premium, or “contango” is the tendency of the VIX futures term structure to trade at a premium to the underlying index. When the curve is in contango, trading strategies can be constructed to attempt to earn the term structure risk premium.

 

When the VIX futures trade below the underlying index, the term structure is said to be in ”backwardation” and potentially long position can be opened.

 

Investors can also trade misalignment in the future term structure when an expiration trade at unusual levels compared to the other expirations (e.g. VX1 vs VX2 or VX4 vs VX7).

Contango Backwardation

03.

Mean Reversion

Mean Reversion is another source of return available to volatility traders. The VIX Index exhibits a mean reverting behavior and it periodically returns to its long term average after rising or falling.

 

However, the VIX Index itself is not tradeable and investable proxies like VIX futures tend not to exhibit the same degree of reversion.

 

Nonetheless, combinations of VIX futures do behave in a mean reverting fashion and this characteristic can be used to gain an edge and superior expected returns.

Mean Reversion

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