How Hedge Funds Rake in Cash Shorting VIX Futures

Looking back at the mean-reverting habits of the CBOE Volatility Index (VIX), and how one could have profited

Apr 2, 2015 at 8:25 AM
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First off, I'd like to wish everyone a nice holiday weekend. Normally, we see the CBOE Volatility Index (VIX) get a bit heavy into long weekends, thanks to the extra day of time decay. It's not really a volatility dip, rather a "calendar dip." But alas, the market acts rather weak lately, so we're in one of those spots where "Fear of Weekend News and Monday Gap" seems to trump "Fear of Paying an Extra Day's Worth of Decay."

Then again, it's tough sometimes to isolate the exact impact of time or fear on the price of an option. I remember many years back learning how to solve for two independent variables. VIX is really neither here nor there now, but perhaps VIX would be higher if not for the long weekend. But it's no biggie, as again, we don't sit at particularly interesting levels, so a point here or there won't change my opinion much.

Anyways, I stumbled on an interesting write-up of a paper that I missed last month: "CFTC Study Confirms Impact of Volatility Trading On VIX Futures Prices":

"In a paper titled 'Volatility Derivatives in Practice: Activity and Impact,' the researchers study both the near expiration futures as well as far out contracts five to six months away from delivery and determine that yes, 'the long volatility bias of asset managers acts to put upward pressure on VIX futures prices.'

"Hedge Funds offset this theoretical impact of an upward price bias in VIX 'because they have taken a net short aggregate futures position' in the CFTC's sample, the report noted."

"…The paper revealed a difference in this price bias based on the time to expiration of the derivatives contract. At the longer end of the futures curve, with contracts expiring 5 to 6 months out, 'non-dealer positioning has a long bias that results in upward pressure of 1.5 vol points,' the paper observed."

As we note very often, VIX futures trade in an almost permanent state of contango. And that's especially true as you travel out the time curve. There's literally a permanent assumption that VIX will tick higher "tomorrow."

It makes sense, in that many use volatility "assets" as portfolio hedges. It doesn't make sense in that paying a perpetual premium for VIX "time" rarely pays off. Go ahead, go to and plug in any date in the past, then see where the five-to-seven-month VIX futures traded on that date. Then go to the Chicago Board Options Exchange (CBOE) site and see where VIX ultimately settled for that cycle. Dollars to doughnuts, VIX settled lower than the VIX future traded on the randomly selected date.

That's because there's actual value in owning "time" in a VIX future. That's not to say VIX futures curves shouldn't slope up, however. That's because VIX does indeed mean revert over time. So, if the perception of a VIX mean rests higher than the current VIX, it does make sense to see an upward-sloping VIX curve. I would suggest that the marketplace over-thinks this concept of mean reversion. The long-term VIX mean is about 20, while the median is about 18. But, in shorter time frames, the true VIX mean is often lower than that. We're five years into one of those stretches -- quite simply, a lower VIX regime.

I'm guessing hedge funds see something like that, which is why they keep a net short position out in the curve. There's pretty clearly a price edge in shorting VIX futures out half a year. There's risk, of course. This low-vol era won't last forever. But, a hedge fund with deep pockets and some sort of discipline to close out at some juncture has probably raked in serious cash on this play.

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


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