This is a question that has come up a lot recently and I wanted to do a short explanation here. I plan on doing a more extensive article on this later which will be featured on my SeekingAlpha page.
Let's say that currently VIX futures are in 7% backwardation.
If we break this down here is what affect that would have on an inverse volatility product:
- 7% value loss over a period of one month as futures roll from the second to the front month contract.
- There are typically around 21 trading days per month.
- 7 divided by 21 equals 0.33%
Your daily drag from backwardation would average around 0.33%.
Now, let's say that the VIX futures (front and second month) fall 1% during the trading day. This would leave a theoretical gain of 0.67% minus any fees of the fund or deviations from the NAV.
Long story short:
If the VIX futures fall faster than the rate of backwardation, inverse volatility products will go up. This is also true for long volatility products when volatility futures rise faster than the rate of contango.
I just wanted to clear up a common misconception I have seen lately.
Have a great week. I should have an article published on SeekingAlpha either today or tomorrow.