Volatility ETNs: Exposure to What Exactly? – $VIX, $VXX

by CC March 25, 2015 10:52 am • Education

In a post last week I went over some potential portfolio hedges using VIX and SPY options.

We have a preferred VIX (long vol) strategy that we put from time to time and we’ll probably do that soon of the VIX continues to get crushed, possibly looking out a few months to catch the next Fed meeting as that seems like the only thing that matters for the market. After I published that post on portfolio hedging someone asked me about the VXX as a hedge (sarcastically? not sure). I’ve written about these products before but the question reminded me that I hadn’t in a while. I should write about these all the time because they piss me off.

First, let’s pick on the VXX. It’s not the only one of the “VIX exposure” ETNs but it’s probably the most famous. VXX is a Barclay’s iPath product. Here’s how they describe it on their product summary page:

The Index is designed to provide access to equity market volatility through CBOE Volatility Index® (the “VIX Index”) futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects market participants’ views of the future direction of the VIX index at the time of expiration of the VIX futures contracts comprising the Index. Owning the ETNs is not the same as owning interests in the index components included in the Index or a security directly linked to the performance of the Index. For additional information regarding the risks associated with the ETNs, please see “Selected Risk Considerations” below.

Got that? Of course not. Here’s a better explanation:

Screen Shot 2015-03-25 at 8.15.55 AM
VXX “performance” from Yahoo Finance

The product is trading $25, down from $7000. So let’s fix the product summary:

The Index is designed to provide access to your money by others. The Index offers exposure (meaning you hemorrhage money almost every day) to a daily rolling long position in the first and second month VIX futures contracts and you probably have no idea what that means but go ahead, buy it.

So let’s talk about what this ETN is actually exposing you to and why you shouldn’t go anywhere near it as a long vol play. The way VXX works is its ostensibly a long VIX holding based on the 1st and 2nd month futures of VIX. And that’s true for a couple of hours. The problem is that very few people are in this ETN for just a few hours. Once you hold this thing overnight what you are essentially betting on over time is whether the VIX futures are in contango or backwardation. I won’t go too in depth on contango and backwardation but let’s go over the basic gist as it applies to the VXX.

The VXX has to keep a long futures holding with a window of 2 months ahead. The only way to do that is to roll those futures contracts each day. In that roll, when the futures that they buy (out 2 months) are trading higher than the futures that they sell (this month’s), that’s called contango. When the futures that they sell are higher than the ones they are buying, that’s called backwardation. As far as the VXX is concerned, the ETN loses a little bit of money each day on that roll if the VIX futures are in contango, and makes a little bit of money each day when the VIX futures are in backwardation.

Spoiler Alert! The VIX futures are almost always in contango. Remember this chart from a few minutes ago?

Screen Shot 2015-03-25 at 8.15.55 AM

That’s compounded long contango over time with very brief moments of backwardation. The day to day movements of the VIX, which this is supposedly giving the “investor” “exposure” to is irrelevant.

Why are VIX futures mostly in contango? Because contango in VIX futures represents a market that is going sideways or higher.  The only time the futures are in backwardation is during sustained periods of volatility where the VIX is way above its historical mean and therefore futures curve down the farther you go out in time, representing that fact that volatility is ephemeral.

So I hope that makes sense. Bottom line, don’t buy the VXX. I know there are exceptions and you could be right for a day or two. But it’s my opinion that these products should be de-listed rather than splitting 1 for 4 every year or so. The fact that they are so easy to access yet so difficult to understand pisses me off.

Our long VIX futures structures look to avoid as much decay risk as possible and have a fairly easy to understand risk/reward profile. We’ll circle back soon on that trade.