Lately in that location were a few interesting discussions inward the blogosphere on the profitability of shorting the VXX-VXZ spread. (See Quantum Blog in addition to The Speculator's Ball.) For background, VXX is an ETN that tracks the showtime in addition to minute calendar month of the VIX future, which inward plow tracks the VIX volatility index, which inward plow tracks the volatility of SPX. VXZ is the ETN that tracks the fourth - seventh months of the VIX future. During the menstruum 2009-2010, in that location were two dissimilar reasons why shorting this "calendar spread" was profitable:
1) The VIX futures were/are inward contango: i.e. the dorsum months' futures are to a greater extent than expensive than the front end months'.
2) The volatility of SPX was decreasing alongside time.
However, unopen to traders appear to intend that either 1 of these weather is plenty to ensure the profitability of shorting a calendar spread. It is not. (Otherwise, life every bit a futures trader would endure also easy!)
To run into this, let's resort to a simplistic linear approximation to a model of futures prices. From John Hull's mass on derivatives, department 3.12, the cost of a futurity which matures at fourth dimension T is
F(t, T)=E(ST)exp(c(T-t)),
where E(ST) is the expected value of the spot cost at maturity, c is a constant, in addition to t is the electrical flow time. If the futures are inward contango, hence c > 0.
If nosotros assume that abs(c) is small, in addition to T-t is also modest (i.e. non also far from maturity), in addition to that the expected value of the spot cost changes slowly, nosotros tin linearize this formula as
F=(a+b(T-t))*(1+c(T-t))
If the marketplace expects the futurity spot cost to increase, hence b > 0.
After a few elementary algebraic steps, you lot tin verify that the calendar spread's cost is proportional to
F(t, T1)-F(t, T2) bct
where T1 < T2 (i.e. F(t, T1) is the front end month's price, and F(t, T2) the dorsum month's).
This is a satisfyingly illustrative result. It says that shorting this calendar spread volition endure profitable if
A) futures are inward contango and the expected spot cost inward the futurity is decreasing; or else
B) futures are inward backwardation and the expected spot cost inward the futurity is increasing.
So what is the province of affairs today? Will it all the same endure profitable to brusk this spread? As our beau bloggers accept pointed out, VIX futures are all the same inward contango, exactly the marketplace is expecting volatility to increment inward the futurity over the concluding calendar month or so. So this may no longer endure a profitable merchandise anymore.
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