Shifting markets mean opportunity with VIX contracts

Author: Robert Zingale

Covestor model: Volatility Mean Reversion

I recently switched my strategy to focus on hedging the iPath S&P 500 VIX short-term fund (VXX) by taking a position in the iPath S&P 500 VIX Mid-Term Futures (VXZ)--or solely shorting VXZ depending on the VIX term structure.

Although short-term VIX futures are experiencing a high rolling cost, which is working in favor of my short VXX position, I am considering solely shorting VXZ to profit from a flattening term structure.

Currently mid-term VIX futures, which comprise VXZ, are at the middle of their historical price range; however, short-term VIX futures are at the low-end of their historical range. Since price declines in short-term VIX futures may be running out of steam, I believe shorting VXZ may provide both price decline and high rolling costs, which would both support establishing a short position in VXZ.

The VIX futures term structure may flatten if investors' long-term market expectations become less uncertain and more upbeat. Given the recent positive economic data coming out and strong corporate earnings last quarter, this scenario is becoming more likely. The main risk preventing this scenario occurring is the continuing uncertainty regarding the European debt crisis.

If I make a change to my current portfolio allocation, this change will occur around contract expiration to capture the larger rolling cost from VXX before getting out of the position.

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