How Time Decay Affects the Value of VXX

Questioning some conventional wisdom about iPath S&P 500 VIX Short-Term Futures ETN (VXX)

Adam Warner
Feb 9, 2015 at 8:45 AM
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If CBOE Volatility Index (VIX) futures sit in contango, iPath S&P 500 VIX Short-Term Futures ETN (VXX) gradually loses money. I'm pretty sure everybody agrees on that point. So why does that happen?

The conventional wisdom is that VXX loses money selling the shorter cycle and then paying a higher price for the ensuing cycle. But Vance Harwood makes a compelling case that this assumption is actually incorrect. I can't do his piece justice with a simple excerpt, so let me try to explain.

Let's say in order to maintain 30-day duration, VXX needs to sell $X worth of near-month VIX futures. That is equal to a quantity of Y. VXX then uses those $X to buy the next month futures. Since the curve is in contango, $X will buy fewer than Y futures in the second month.

Vance's point is that this doesn't actually devalue VXX in any way; in fact, it's the same (disregarding expenses and interest). Yes, VXX now owns fewer VIX futures, but the "value" of VXX hasn't changed. Consider me converted; I agree with his analysis.

But VXX does indeed decline when VIX futures sit in contango -- it's just not for the reason we tend to throw out there. Rather, it's more akin to the time decay of a regular put option.

Consider this hypothetical trading world where CBOE lists a new 30-day VIX future every day. All VXX has to do is put 100% of its cash into that future on the open and hold for 24 hours until the next open. Then, it sells that future (now only 29 days' duration) and buys the "new" future.

(We'll also say VIX itself does absolutely nothing, and the value of a 30-day VIX future also remains unchanged. Oh, and VIX futures are in contango.)

VXX buys the 30-day VIX future, and (blink blink) 24 hours passes by. With everything held as constant, the future held by VXX has to have declined over the course of the 24 hours. And, ergo, VXX has declined in value, entirely independent of any rolling transaction. Why's that?

Because in this world we constructed, any futures VXX holds lose value literally as the ink dries. CBOE could list a new future every hour, or every minute, or every nano-second, and it would still happen, so long as we stipulate that there is value in time (i.e., contango).

But we really didn't "construct" this world, we just isolated some variables. VIX futures really do trade in contango most of the time, and VXX does lose value over time under a contango regime. It just happens for a different reason than I thought. Time decay is the cause, not the actual act of rolling.

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


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