The Deadliest "Free Money" Trade (Patreon)

What if I told you there was a way to short this graph? 

Above is the S&P 500 VIX Short-Term Futures Index. 

The index is based on the from-month VIX futures contract, as well as the contract that will expire the following month.

Each day, a portion of the front-month contract is sold, and the same amount of the next-month contract is bought, to create a constant maturity synthetic future that measures how much the short term VIX futures make or lose over time. 

None of that is important. 

The important thing is that it's a line on a chart going down in a big way. A REALLY big way.

And if you can find a way to short that line, (without imploding) you might be able to finally upgrade the broke-mobile to the lambo. 

Observation 1 - Buying short-term VIX futures incinerates money over time 

With an annualized return of less than -45% per year over the past decade, we can see a strategy that's able to short these futures would print money. 

Observation 2 - There are exchange traded notes that do this

There are ETNs that do this exact thing: SVXY and SVIX. 

These two are meant to replicate a .5x and 1x exposure to shorting a basket of VIX futures, as VIX futures are large and costly to trade for retail degens. 

Shorting the Leveraged VIX ETNs (UVXY, UVIX) is also a decent trade because of volatility drag, but that's a story for another time.  

How Can We Trade This? 

Before we get into this, be warned.... venturing into volatility ETN land is a dangerous path, riddled with the carcasses of many volatility sellers before you.

                     Above guy turned 50k into ~$4,000,000 in XIV then lost everything

Remember how a guy lost 4 million dollars trading XIV? SVIX is essentially the same product lol. 

I do think there's a way to trade these things without blowing up, but proceed with caution. 

The VIX Index

This is boring af, but important if we wanna gamble on short VIX ETNs. 

The VIX is an index that tracks the 30 day implied volatility of S&P options. 

Looking at the VIX chart, we can see it's mean reverting. 

If we could trade the VIX directly, all we'd need to do is go long whenever it's in the teens, and short whenever it's around 25.

Unfortunately, we can't trade the VIX directly. We can only trade the futures. 

And because mfs know the VIX mean reverts, this reversion gets priced into the futures. 

• The futures trade above the VIX price when it's low (it costs you to be long)
• The futures trade below the VIX price when it's high (it costs you to be short) 

This spread between the VIX futures price and the spot price is called the basis. 

A positive basis means you get paid to sell the futures, because everyone thinks the VIX is going up. 

A negative basis means you get paid to buy the futures, because everyone thinks the VIX is going down. 

A good proxy for the basis is the term structure of implied volatility. 

When the shorter dated VIX contract is very low compared to the longer dated ones, the term structure is said to be in contango, and the basis is positive in a big way. 

This suggests the market volatility is low, but everyone expects it to go up drastically in the next few months. 

Not a fun place to sell VIX futures. 

When the shorter dated VIX contract is very high compared to the longer dated ones, the term structure is said to be in backwardation, and the basis is negative in a big way.

This suggests market volatility is high, but everyone expects it to go down in the next few months. 

Not a fun place to buy VIX futures. 

Here's a time series of the basis. 

Notice how it was negative in a super big way during COVID. Everyone knew the craziness would eventually calm down, so it cost a lot to short the futures. 

However, we can see how it's almost always positive. VIX futures buyers consistently have to pay a premium to be long, hence the reason why the VIX Short Term Futures Index has incinerated money. 

This leaves us with a few things to consider:

• Just shorting the VIX futures seems to print money over time
• Shorting a high VIX means we have a strong tailwind of mean reversion, but have to pay to carry the position
• Shorting a low VIX means mean reversion is working against us, but we get paid to carry the position

Knowing this, if we're looking to sell VIX futures (by buying SVIX or SVXY), we need the basis to be very large when the VIX is low, but continuously less large as the VIX gets higher.

This will make it so we're only fighting mean reversion when we're getting paid a lot to do it, or paying when we know the reversion is strong af. 

If we divide VIX/VIX3M we can calculate a metric called the Implied Volatility Term Structure (IVTS). As you can probably guess, it's a measure of the term structure of implied volatility.

Some dude wrote about this calculation in a book. 

High values mean the term structure is very backwardated, low values mean it's very contango-ated.

A value of 1.2 means you'd have to pay to short VIX futures, because the world's probably losing its fucking mind and everyone knows volatility is going to drop eventually. 

A value below 1 means you get paid to short VIX futures, because nothing is happening, and the world has that anxiety you get when things are going too good for more than 3 days in a row. 

I wanted to see the returns of a strategy that buys SVXY when the level of contango is high given the level of the VIX.

I labeled each day's VIX and basis values with percentiles then added some arbitrary cutoffs for each. 

For example if the VIX is lower than 90% of its historical values, we need the IVTS to be lower than 80% of its historical values.

If the VIX is lower than 60% of its historical values, we need the IVTS to be lower than 50% of its historical values.

And so on......

Above is a strategy with no transaction costs that puts 100% in SVXY when our basis-level cutoff is met. 

It looks good. 

I jumbled the cutoff values around a bunch of times to make sure this wasn't just some lucky parameter selection, but it seems to do well no matter what. 

Obviously you'd never get this jacked in one of these short vol ETNs, (as they tend to catastrophically implode occasionally) but this just shows the effect is a real thing.  

I'm going to continue to do research on this and update it on here. I usually just hold SVXY because it prints, but from this I definitely think there are ways to improve that.