Has anyone noticed a bit more volatility in markets these days? That SNB shocker was something, indeed – it seems some FX retail brokerage houses have already declared insolvency. Anyway, the increased volatility has had quite an impact on VIX in the year so far: after starting the year at an elevated, yet respectable 17-ish, the index has climbed to a panic-like 22.5. For those stats-minded, that latter figure implies a daily move of around 1.4% for the SPX – not unusual recently, but pretty darn high compared to post-2008.

OK, let’s get to work. The VIX is very elevated, but it can be a mug’s game to short (i.e. the VIX can get smashed a bit like the SNB smashed the Euro/CHF exchange rate yesterday). Too risky for an outright short. What to do?? **A VIX calendar spread.**

**Hypothesis:**times of high volatility causes the VIX futures curve to go from contango (e.g. further months more expensive than near months) to backwardation (the opposite). When the market returns to more normal conditions, the contango will return.**Method:**when the futures curve goes to backwardation, or very near it, go short a near-month future and hedge by going long a further-dated future. Take off the trade when contango returns.**Which contracts?**Note the curves in the picture. The red line is today’s VIX futures curve – e.g. flat to backwardated. The other lines are the month-end VIX futures curves for the past 6 months. A couple observations:- In normal markets, there is a pretty smooth contango. So the max return for any 1-month calendar spread is about the same going out 6 months. You could choose, say, months 2/3, 3/4, etc.
**However:**notice how much extra movement occurs in months 1 & 2, say, relative to further months. So, it’s a risk/return situation: if you want higher risk/return, go for earlier months. I, being a chicken, will stick with a bit less risk – months 3/4, perhaps. That means I choose to be short Apr 2015, hedged by long May 2015 futures.

**A bit of data mining to convince me:**I downloaded the month 3 and 4 continuous contracts from Quandl, then did the following rough analysis:- Time range: 1 Jan 2008 through yesterday, daily data.
- Metric: gross profit from Month 3 and 4 calendar spread, assuming a 1-month hold (i.e. mechanically holding the position 1 month).
- Brief, dirty stats:
**Unconditional (e.g. all daily observations)**- Observations = 1740
- Mean gross return = $0.006/spread
- Expected return, using uniform probability distribution and decile returns (including min/max) = $0.033/spread
- Z-test for mean different than 0 = 36.8%. In sum, I can’t assume the expected return is positive.

**Conditional (e.g. only enter trade when spread is $0.05 or less)**- Observations = 454
- Mean gross return = $0.341/spread
- Expected return, same method = $0.320/spread
- Z-test for mean different than 0 = less than 0.01%. In sum, I can assume a positive return.

**Summary:**I think this strategy will work in the current environment, so I’ve put on the trade in small size to test the waters. Wish me luck!

A follow up here: I closed this trade last Friday, as the contango was starting to look pretty good. Overall the trade made about $0.25, or $250/pair. Not quite the mean return, but I’d rather pocket most of the expected return for a short hold period.

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Made this trade with pen on paper and watched it from the sidelines – nice call Matt! The curve reverted back pretty quickly; I’ll have to spend some time on historical data with this one.

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