In the previous article, we have explained that the VIX index is one of the most important entry parameter when it comes to our system for shorting volatile ETFs. Today, we will focus on specifying why it is so and how important for the success of the strategy is the length of the trade (that can also be associated with the chosen time until the expiry of the option contracts). Today’s part will be more visual, but as they say – one image/chart says more than 1000 words. To be complete, I add that Charles Bridge has worked on these models with Pavel Hala – the founder and chief architect of the SpreadCharts.com project.
First, we need to define the statistical breakdown of the VIX index value, which is shown by chart 1 (all time) and chart 2 (low volatility time). For model purposes, the low volatility period had been defined as the period between 2004-2007 and then 2012-onwards. It is simply a period when there had been a significant intervention of central banks on the economy in the form of QE and other incentives, or there had been a credit boom in the private sector (growth of bank loans).
The key values for entering a shorting strategy – eg bear call/put spreads – in this case ETN: VXX are first flat derivation of the probability distributions, ie basically 3 levels: 19/20 – 27 -aprox. 30. In low volatility times (chart 2) it is considered as a success to buy at VIX = 19, but then a high chance of success is subsequently guaranteed.
Chart 3 also suggests that it is advisable not to wait until the expiration of contracts, but to collect profits after roughly 6 months. The reason is cyclicity of the volatility spikes. If such a volatile spike would occur in the last quarter of the strategy’s lifetime, it might bring a serious threat to it. This is the reason why, in the vast majority of cases, we exit the strategy with about 85-90% of the potential profit or not less than 3 months before the end of the option expiration.
Finally, the following 3D graph clearly captures the relationship between the probability of the strategy success (win) depending on the length of the expiration, respectively on the length of position holding, and the VIX index value, when entering to the trade.
It is therefore possible to draw a completely logical and clear conclusion. The longer is the time you spend in the position, the better chance of success of the strategy (for the low volatility period). For the models, the average expected contango rate was 4%, respectively. 2%. For you idea, the average realized contango of 2% would sustain the “crisis” of 2008 (pre-Lehman) and “the European crisis in 2011”.
An implied 2% contango is likely to survive even the loosing year on S & P, the implied 4% contango should survive a flat year.
The concept of implied contango will be disputed in one of the other parts of the educational series. It is in principle decisive point for the identification of the points up to where the market can move within a given timeframe and hence for identifying the option strikes when shorting markets like VXX, UVXY, etc.