The Messy Relationship Between VIX and VXX

So what happens when a bunch of options folk start debating what goes into the price of iPath S&P 500 VIX Short-Term Futures ETN (VXX)? Twitter threads like this.

The debate was whether or not the relationship of the CBOE Volatility Index (VIX) itself to the near-month VIX futures impacts VXX. I come down on the side that "spot" VIX does indeed impact VXX -- namely, if VIX futures trade at a premium to VIX, then VIX will ultimately drag VXX lower. But that's my conclusion, or at least my opinion, so let me go back and explain how I get to that point.

VXX proxies a VIX future that has a constant duration of 30 days. It accomplishes that task by investing in some combination of VIX futures and OTC VIX swaps. Since it must maintain 30 days' duration, it must constantly roll "out" in time in some fashion. If the near-term VIX futures curve is sloped upwards (contango), VXX will lose money on the roll. It's not much money day over day, and it's by and large been a benefit in 2015, as near-term VIX has often resided in backwardation. But VIX futures mostly trade in contango, VXX mostly loses money rolling, those losses add up, and the end result is that VXX has lost 99.5% of its value from its split-adjusted opening price of $6,400 from almost exactly six years ago.

None of that is debated. What is in question is the role VIX itself plays in all this.

Let's say the near-month VIX term structure is completely flat. The nearest-month VIX future equals the next-month-out VIX future, and there's no "kinks" in between. Thus VXX can maintain 30-day duration at zero cost. And let's say that the futures curve remains perfectly flat, and both trade at premiums to VIX itself. And we'll add that VIX itself is relatively flat. What happens to VXX?

On day one, probably nothing -- and maybe nothing on day two or day three, either. But, eventually, something has to give. The actual futures themselves will converge to VIX and equal VIX (settlement VIX) on the day they expire, but the rolled hypothetical future always has 30 days to expiration and doesn't have to converge. But that's not realistic behavior. A VIX future is essentially a "bet" on the price of VIX on the day the future expires. If VIX is perpetually lower than the VIX future, then it's highly likely that VIX futures traders will eventually pay lower and lower premiums to VIX over time. And as those VIX futures drift, VXX will drift.

The counterargument is that it could work the other way. Instead of VIX futures ultimately drifting towards VIX, VIX itself moves towards VIX futures. Anything is possible, but this feels like the far less likely outcome. VIX futures are a derivative of VIX itself. A tail can wag a dog. S&P 500 Index (SPX) futures can move SPX itself … in fact, they do it over and over again every day. But there's a crucial factor in that relationship -- there's a defined arb between the two. SPX futures are worth exactly the basket of SPX stocks, plus the cost of carry, between now and futures expiration. Thus, when futures are out of line with SPX, there's a lightning-quick mechanism to put them back in line.

VIX has no such dynamic. Futures are sentiment driven. It's my strong opinion that the sentiment driving futures premium will change over time and lead the future towards VIX itself.

The best analogy I can come up with is the relationship of an option's implied volatility to the realized volatility of the underlying. They don't have to ever be equal. Traders can, and often do, pay implied volatilities that are far greater than backwards-looking realized volatilities. But over time, that's a money-losing strategy if the realized volatility never picks up. And logic says eventually the traders will pay lower implied volatility for the options. Can realized volatility converge to implied volatility instead? Yes, but it's the less likely path over time.

All that's a long-winded way of saying I can't "prove" that VIX futures ultimately converge towards VIX. There are too many moving parts in the real world. But it's my strong opinion that the relationship of VIX to VIX futures does drive VXX over time.

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