Futures returns consist of ii components: the returns of the spot cost too the "roll returns". This is sort of obvious if y'all cry back nearly it: suppose the spot cost remains constant inward fourth dimension (and hence has aught return). Futures amongst unlike maturities volition soundless own got unlike prices at whatever indicate inward time, too yet they must all converge to the same spot cost at expirations, which way they must own got non-zero returns during their lifetimes. This whorl provide is inward activity every day, non only during the rollover to the adjacent nearest contract. For some futures, the magnitude of this whorl provide tin sack endure real large: it averages nearly -50% annualized for VX, the volatility futures. Wouldn't it endure squeamish if nosotros tin sack somehow extract this return?
In theory, extracting this provide should endure easy: if a futurity is inward backwardation (positive whorl return), only purchase the futurity too brusque the underlying asset, too vice versa if it is inward contango. Unfortunately, shorting, or fifty-fifty buying, an underlying property is non easy. Except for precious metals, most commodity ETFs that concur "commodities" truly concur entirely their futures (e.g. USO, UNG, ...), too so they are of no assist at all inward this arbitrage strategy. Meanwhile, it is too a chip inconvenient for us to become out too purchase a few crude oil tankers ourselves.
But inward arbitrage trading, nosotros ofttimes attain non involve an exact arbitrage relationship: a statistical probable human relationship is adept enough. So instead of using a commodity ETF every bit a hedge against the future, nosotros tin sack purpose a commodity-producer ETF. For example, instead of using USO every bit a hedge, nosotros tin sack purpose XLE, the unloosen energy sector ETF that holds unloosen energy producing companies. These ETFs should own got a higher bird of correlation amongst the spot cost than attain the futures, too hence real suitable every bit hedges. In cases where the futures attain non rail commodities (as inward the instance of VX), however, nosotros own got to await harder to discovery the proper hedge.
Which brings me to this fresh-off-the-press paper past times David Simon too Jim Campasano. (Hat tip: Simon T.) This newspaper suggests a trading strategy that tries to extract the real juicy whorl returns of VX. The hedge they advise is -- y'all guessed it! -- the ES future. In a nutshell: if VX is inward contango (which is most of the time), only brusque both VX too ES, too vice versa if VX is inward backwardation.
Why does ES move every bit a adept hedge? Of course, its real negative correlation amongst VX is the major factor. But ane should non overlook the fact that ES too has a real modest whorl provide (about +1.5% annualized). In other words, if y'all desire to discovery a futurity to deed every bit a hedge, await for ones that own got an insignificant whorl return. (Of course, if nosotros tin sack discovery a futurity that has high correlation amongst your master copy futurity but which has a high whorl provide of the contrary sign, that would endure ideal. But nosotros are seldom that lucky.)
P.S. The reader Simon who referred me to this newspaper too drew my attending to an apparent contradiction betwixt its determination too my before spider web log post: Shorting the VIX Calendar Spread. This newspaper says that it is profitable to brusque VX when it is inward contango and hedge amongst brusque ES, acre I said it may non endure profitable to brusque the front end contract of VX when it is inward contango too hedge amongst long dorsum contract of VX. Both statements are true: hedging amongst the dorsum contract of VX brings real trivial attain goodness because both the front end too dorsum contracts are suffering from real similar whorl returns, too so at that topographic point is trivial provide left when y'all accept contrary positions inward them!
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