How Much VXX is Enough?

Another week, another churn with a sour ending, and another mediocre CBOE Volatility Index (VIX). I will say this, though -- it's incredibly fairly valued for this backdrop. Ten-day realized volatility in the S&P 500 Index (SPX) is in the low 10s. VIX typically sees a four-point premium to that, thanks to the open-ended nature of volatility pops, and the fact that the entire world wants to either protect against a downside market move or speculate on one.

VIX is in the mid-13s, which I suppose is slightly cheap on that "metric," but it's close enough -- and "typical" is inexact enough that I'll say it's very fair. Our good friend the iPath S&P 500 VIX Short-Term Futures ETN (VXX) did its usual VXX thing last week. Despite a market that dipped about 1%, VXX did very little. And, of course, it hit both all-time intraday (15.48) and all-time closing (15.74) lows on Wednesday.

But again, I'm not here to torture VXX for the eleventy-billionth time, I'm here to praise it ... for (I think) the second time. The more I focus on the short term, the more I say it's possible to use this pup without getting too badly burnt. Last week we looked at how VXX correlated and traded vs. VIX. This week we're going to look at VXX vs. the SPDR S&P 500 ETF (SPY).

Since the start of VXX time, it has a negative 0.80 correlation with SPY, and that makes some sense. That's because it's about the same negative correlation as VIX vs. SPY. But that's just the correlation of a one-day move. What if we look at how VXX does on different time frames?

Well, I did, and it's not terrible. If you look at three-day moves, it has about a negative 0.78 correlation. Go to one week, and it's negative 0.75, and over two weeks it's negative 0.71. It obviously trends down, but even out two weeks, VXX is hardly a disaster. Of course, if we keep going, it gets worse and worse, mainly because VXX itself gets worse and worse. In the short term, though, it's clearly possible to accomplish something.

So, how much VXX should we use to hedge? Well, over the course of forever, I come up with a day-over-day "beta" of about negative 2.77. What's interesting is that this number doesn't move a lot if I spread out the time frame like I did with correlations. Over three days, it's negative 2.8, and over a week it's negative 2.74.

So, if your goal is to hedge market moves with a volatility exchange-traded fund (ETF), and your time frame is on the short side, VXX can really work! Use about a 20-25% dollar amount ratio and don't hold it for very long. And laugh at so-called "experts" like me who would advise against VXX ownership!

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research