VIX tracking ETN’s – There’s no such thing as a free lunch

by CC April 20, 2011 3:41 pm • Commentary

Dan and I have been thinking alot recently on the best ways to play marketwide volatility. Dan has had some success recently in trading options in the VXX, but also taken some pain on on some earlier trades in that beast. I personally had some success in going long the XIV (VelocityShares Daily Inverse VIX Short Term ETN) during the Japanese nuclear crisis, using it as a hedge when the SPX was near 1250 vs. some market shorts. I want to discuss these types of products and why they are so risky as anything other than a short term bet.

In an ideal world, investors and traders would be able to use Volatility indices in their portfolio as a hedge against market crashes and corrections. Alot of products have been launched in the past few years to attempt this.

Since the invention of options, most market participants have hedged portfolios or single stock holdings in the form of puts, collars, risk reversals etc. in the underlying stock or index. An index was created that attempted to give a sense of how this options hedging was trading as a whole. The VIX. At the risk of oversimplifying, the VIX is an index that measures the combined implied volatility of options on the S&P 500.

Now back to VXX et al. The VXX is an ETN issued by iPath. It attempts to track short term futures in the VIX. If your head is starting to spin, it should. The VIX has futures. The VXX tracks those futures. (a derivative, of a derivative, of a derivative, of a… well, you get the point) The problem with anything that tracks futures is they can hemorrhage money on something called contango. Contango, again to oversimplify, is when the spot price of the future is below the price of the future month it needs to roll towards at expiration. E.g. The front month is expiring at 18, the next month out that needs to be bought trades 20 = your index losing 2 dollars. This happens all the time in an ETN like VXX.

The best way to think about this, is VXX (and other instruments like it) has decay. It’s not that different than being long premium in the form of puts. If one were to buy calls in VXX (or something similar) one would be long premium that decays, on something that essentially mimics being long premium that decays. This is like playing Russian Roulette where 5 of the chambers have a bullet, and the other one spits out 10 thousand dollars.


In other words. You better be right, you better be right fast, and you better run as soon as that $10k shoots into your ear.

I haven’t looked into all of these things, but what has struck me is that the short VIX futures instruments (e.g. XIV) seem to fare much better in mimicking the price of the VIX futures. FT Alphaville did a pretty good job explaining why it’s so hard to mimic the VIX. You can read their take here.

Dan and I are going to keep our eyes on this stuff and figure out the best ways to play these things. Like I told Dan last night, if there were instruments out there that traded one to one with VIX futures, had no contango, had no decay, were mean reverting when the VIX was at say 12 or 60, and had no expiration? I may not trade anything else but those for the rest of my life. Because that my friends, would be a free lunch. Unfortunately, there’s no such thing as a free lunch yet.