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VXX/VXZ Pairs Trade

Barclays has made it a priority to create exchange traded notes (ETN’s) that capture market “factors” that investors normally do not have access to.  In “Hedging Equity Risk with VIX Futures” I discussed the idea of going long VIX futures as a supplement to a long stock portfolio in order to reduce maximum equity drawdowns.   In the follow-up article, I expanded on this idea with the iPath S&P 500 VIX Short-Term Futures ETN(VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) and how these two investment vehicles provide an easy way to bet on volatility and the VIX futures curve.

In addition to being able to hedge your equity position directly with a long position in VXZ, I suggested that an interesting strategy would be to short the short-term note (VXX) while going long the mid-term note (VXZ).  By selling the front and going long the back of the VIX futures curve, you effectively take advantage of a steep futures curve.  The question is always: “So what were the results?”

I hesitate to put too much emphasis on the outcome of a strategy with investment options that were only first available a year and a half ago, but I find it interesting nonetheless.  By shorting 1 share of VXX and going long 2 shares of VXZ you would have doubled your money with a 23% standard deviation over the nearly 1 1/2 years since the funds’ inceptions:

The strategy had a Sharpe ratio of nearly 3

This is a leveraged result in which you sell one share of VXX to purchase one share of VXZ and then use your original $100 to buy an additional share of VXZ.  I have ignored leverage requirements and funding costs in this example so you effectively get a daily return that is -1 times the VXX return and +2 times the VXZ daily return on your original $100.  The strategy’s worst drawdown of -16.4% occurred in a little over a month when the equity markets rallied from the lows and volatility broke down through its elevated trading levels.

I have a hard time making a long-term strategy based upon this limited time-series during very abnormal market conditions, but it can highlight the overall efficacy of the idea.  It will be interesting to extend this study directly to VIX futures.  My assumption is that the strong market corrections of 2008 would create large negative drawdowns when short-term volatility spiked much more quickly than longer term volatility.

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