Should You Pay For Fancy Trading Algorithms?

Breaking down a simpler approach to trading in times of contango or backwardation

by Adam Warner

Published on Nov 10, 2015 at 10:06 AM

Looking to pay someone to access his CBOE Volatility Index (VIX) exchange-traded fund (ETF) bot? Well, there's this:

"Based on 17 years of experience, I created an algorithm that's giving me a 60.87% hit rate trading XIV, SVXY, VXX, TVIX, and UVXY.

"My Algorithm VRP+T4TM is Providing Returns of 193.67% YTD

"With access to my algorithm, you can trade volatility ETPs like a professional and confidently reduce the emotional toll of trading."

Or if not, there's this:

I've never seen this first guy's algo, or evidence of his returns. He may have a great product -- though I'm always leery of someone trying to sell silly-great returns. If you can book those kind of returns, why share the secret with anyone? But I'm going to stick with @selling_theta here.

As we well know, the long VIX ETF complex struggles when the VIX futures curve is in contango. In such a setup, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) loses money over time, and leveraged trackers like the ProShares Trust Ultra VIX Short Term Futures ETF (UVXY) and VelocityShares Daily 2X VIX Short-Term ETN (TVIX) face pressure from the contango -- the compounding effects that hit all trackers, and the impact of leveraging all that.

When the VIX curve is in backwardation, the whole equation flips the other way. The passage of time now helps VXX. And if VXX is going one way and up, the compounding and leverage now give UVXY an extra bump.

So, yes, the simple principle of trading VXX and friends off the short side when VIX futures are in contango -- and flattening or going long when it's in backwardation -- is probably as good a guideline as any.

I would never go straight long VXX though. By definition, you'd have to do it while VIX futures are flying and that's not exactly the timing I'd prefer. I can see going long VXX vs. long stock futures or ETFs, as a pair -- though at times of backwardation, particularly early in the flip to backwardation. Remember that the whole VIX board always builds in assumptions of future mean reversion. When stocks get hit and VIX itself starts to pop, VIX futures will lag at first. Think about what we saw in August, for example. There's some opportunity there to buy VXX (or something like it) vs. stocks. If the sell-off persists, VXX figures to outperform going forward from there, as the VIX futures start to catch up to the new "mean." If the sell-off reverses -- well, VXX won't do well, but the stocks will. It's a de facto gamma long play, minus the decay of actual options at ramped vol.

I'm not guaranteeing any sort of returns on that, or even that it will work! Specifics matter. It's just a conceptual idea.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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