Stop Buying VXX to Trade Volatility. Tom Preston Says There Is a Better Way.

Key Concepts

• VXX (iPath Series B S&P 500 VIX Short-Term Futures ETN): An Exchange-Traded Note designed to provide long exposure to market volatility by holding a portfolio of VIX futures.
• VIX Futures: Derivative contracts based on the expected future value of the VIX index.
• Contango: A market condition where the price of a futures contract is higher than the current spot price or a nearer-term futures contract.
• Backwardation: A market condition where the price of a futures contract is lower than the current spot price or a nearer-term futures contract.
• Roll Yield/Drag: The cost incurred by an ETN when it must sell a cheaper front-month contract and buy a more expensive back-month contract to maintain its position.
• Defined Risk Strategies: Trading approaches (like spreads) that limit potential losses, as opposed to "naked" positions.

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1. The Mechanics of VXX and the "Roll" Problem

The VXX is an ETN that tracks volatility by holding a rolling portfolio of front-month and next-month VIX futures. Because the VIX itself is a cash index and cannot be traded directly, the VXX must constantly "roll" its position.

• The Process: Every trading day, the VXX sells a small percentage (approx. 4.5%) of its front-month futures and buys the next-month futures.
• The Drag: In a standard market environment, VIX futures are in contango (the back-month is more expensive than the front-month). Consequently, the VXX is forced to sell low and buy high daily. This creates a persistent downward price bias, which is why the VXX has historically required reverse splits to maintain its share price.

2. Analyzing Market Conditions: Contango vs. Backwardation

The speaker emphasizes that the decision to trade volatility should be dictated by the relationship between futures months:

• Contango (The Norm): When the back-month is more expensive than the front-month, the VXX suffers from "roll drag." The speaker avoids buying VXX in this environment, preferring instead to trade VIX futures options (e.g., long call spreads or short put spreads on the front-month) to capture volatility spikes.
• Backwardation (The Exception): This occurs during market crashes when the front-month VIX spikes higher than the back-month. In this rare scenario, the VXX roll becomes profitable (selling high, buying low), creating a positive drift. The speaker would only consider buying VXX under these specific conditions.

3. Risk Management and Trading Strategy

The speaker provides clear guidelines for managing volatility exposure:

• Avoid Naked Shorting: The speaker explicitly warns against being "naked short" volatility. Because market crashes can cause the VIX to spike 10–15 points instantly, a naked short position carries catastrophic, unlimited risk.
• Defined Risk: Whether trading VXX or VIX futures options, the speaker advocates for defined risk strategies (e.g., put spreads or call spreads). This ensures that even if the market moves violently against the position, the loss is capped.
• Futures Nuance: The speaker notes that VIX futures are large products ($1,000 per point), requiring traders to be cautious with position sizing.

4. Key Arguments and Perspectives

• VXX is often a poor long-term hold: Due to the structural decay caused by contango, the speaker argues that VXX is generally not a suitable vehicle for long-term bullish volatility speculation.
• Futures Options over ETNs: The speaker prefers trading options on the VIX futures themselves rather than the VXX, as it allows for more precise targeting of the front-month volatility, which historically reacts faster and more aggressively to market events than the back-month.
• No "Free Money": The speaker clarifies that futures pricing is efficient; there is no arbitrage or "free money" in the relationship between the front and back months. The pricing reflects the cost of carry and market expectations.

5. Synthesis and Conclusion

The primary takeaway is that volatility products are not one-size-fits-all. The VXX is structurally disadvantaged in most market environments due to the daily roll cost associated with contango. Traders looking to speculate on volatility should:

1. Analyze the basis (the price difference) between the front-month and back-month VIX futures.
2. Avoid naked short positions at all costs.
3. Use defined-risk strategies (spreads) to protect against extreme market spikes.
4. Only consider VXX if the market enters backwardation, otherwise, focus on VIX futures options to capture short-term volatility moves.

Disclaimer: The speaker emphasizes that these insights are for educational purposes and do not constitute financial advice.