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As strong as the CBOE Volatility Index (INDEXCBOE:VIX) has looked recently, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has looked even stronger on a relative basis. In a typical day, the VXX should move about 50% of the VIX, but that's an average number that's extremely variable.
Since the close on Friday, Jan. 24 -- the day this volatility pop first went to overbought -- the VIX is up 10%. Over that same time frame, the VXX is up 20.5%. So, in that specific time frame, the VXX has completely overshot the VIX lift.
But, before I go shout "Absurdly Overbought," it's worth looking at why this is happening.
The VXX proxies a 30-day VIX future. Judging by my Twitter stream, many thankfully now know that the VXX has to constantly roll out in time in VIX futures or swaps in order to maintain that 30-day duration. Swaps are flexibly created, so we don't know exactly what they do there. But, we can infer how they make out in that roll by looking at the two VIX futures that surround that 30-day window. Right now, it's February and March.
That near-month spread is almost always in contango, which costs the VXX money every day it rolls, no matter what instrument they use. Now? Not so much. Here's how the term structure looks. (Chart courtesy of VIXCentral, click to enlarge.)
The VXX is actually making money each day. When that spread is small, that money really won't amount to much of anything. But now that it's roughly 0.50 and climbing, it will add up in the VXX coffers.
What's more, you'll notice both the February and March futures (as well as most of the others) are at a discount to the VIX itself. That's mean reversion in action. Markets generally assume that volatility spikes will recede as time goes by. Remember, the market has priced in a high-teens VIX out half-a-year forever. Well, it still expects to see the VIX there -- the only major difference is that the current VIX is higher than that already.
A common myth is that VIX futures know where the VIX is going. They don't. They were wrong most of the time in assuming a lasting VIX rally. The fact that they were right in the last two weeks is more a "broken clock" theory than anything else. If the VIX continues rallying, the VIX term structure will eventually move into complete backwardation, and all cycles will price in a large drop in the VIX. They will probably be right in that instance, but who really knows. Market ugliness feeds upon itself.
Back to the VXX.
So long as the front part of the curve stays in backwardation, and the futures themselves stay at a discount to the VIX, the VXX has the wind at its back. Mind you, in the long term, it's still ultimately going to head towards zero again and again, but short term, it can get difficult to fight at times like this.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.