Sorting Out VXX the Best We Can

Let's take a second to understand what the iPath S&P 500 VIX Short-Term Futures ETN (VXX) really is

Adam Warner
Apr 1, 2015 at 8:20 AM
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I was tweeting up and back the other day about the iPath S&P 500 VIX Short-Term Futures ETN (VXX) with a currency guy, and it occurred to me that now that it's the "it" product again, we better refresh our nuts and bolts -- and what better time to talk VXX than April Fools' Day? So, here's a transcript of an interview I conducted with ... myself:

Q: What does VXX measure?

A: It tracks a hypothetical rolling 30-day CBOE Volatility Index (VIX) future. A VIX future is not VIX itself. It's essentially a "bet" on the price of "settled" VIX on the open of the day the future expires. VIX futures generally trade at a premium to VIX itself.

Q: That sounds great. How do the wizards that run VXX create this exchange-traded note (ETN)?

A: VXX owns a package of futures and swaps that replicate a 30-day future.

Q: So, if VIX futures trade at a premium to VIX, why does VXX always lag VIX over time?

A: That's due to good old contango. So long as the near-term VIX futures curve is sloped up, VXX will ultimately drift. There's a common misconception that the reason it hits VXX is because it loses money rolling out in time every time it buys a higher/longer-dated future and sells a shorter/cheaper one. As Vance Harwood demonstrated, that's not accurate; the money and out is equal. Rather, the dynamic is that so long as time has positive value (a future is worth less so long as it has less time to expiration), VXX loses value by mere virtue of the fact that whatever it owns has less value now than it did a day ago, an hour ago ... even a nanosecond ago. Thus, even if VXX could roll paper every nanosecond, it would still lose money when the futures sit in contango.

Q: That sounds horrible. So, how did the Securities and Exchange Commission (SEC) allow listing of this product to begin with?

A: Well, in all fairness, VXX works as advertised. Quite simply, no one should ever buy and hold VXX. It can work directionally, but it declines over the course of time. You know what else declines over the course of time? An S&P 500 Index (SPX) put -- or any put, for that matter. No one's banning put options any time soon, nor should they ban VXX. Just go into VXX with the knowledge that it's fine to buy it if you expect a volatility spike and/or a market decline, but you better time it well. Again, that's the same criteria you should use for a put option.

Q: If VXX is ultimately going toward zero, why not just short it?

A: Good question. If you can tolerate some spike in your volatility, then yes, sitting with a VXX short will eventually work. But those spikes can get quite violent. And remember that as VIX lifts significantly, VIX futures will likely flip to backwardation. And if that happened, the math works in favor of VXX. Time value helps VXX, further compounding a move that's already painful. Further, a VXX short has open-ended loss potential, much like every short.

Q: There's an exchange-traded product (ETP) for everything nowadays, there must be one that lets you go short VXX more safely, right?

A: I'm glad I asked! Yes, you can "short" VXX that way. VelocityShares Daily Inverse VIX Short-Term ETN (XIV) is an inverse VXX tracker. But, like any tracker, it compounds. Long story short, it loses a bit of value any time the underlying (VXX, in this case) revisits a prior price point. VXX does churn at times. In fact, we just ended a three-and-a-half-month stretch where VXX didn't make new lows . It does always eventually go lower, so XIV does work over time. And since you are going short VXX via a "long," you don't have open-ended exposure. But, it's important to note that over time, an XIV long will underperform a straight VXX short, even factoring in occasional short-borrowing costs.

Q: That's a lot to digest. Give me one final conclusion.

Only go long VXX with a short-term play in mind. You're not betting on VIX, per se. Rather you're betting on the short-term directional move of VIX futures. Shorting VXX sounds great, but make sure you have the stomach for a quick drawdown.

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


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