VXX Trading: What Contango Does to Your Position

Key Concepts

• VXX: An Exchange Traded Note (ETN) that tracks short-term VIX futures.
• VIX Futures: Contracts representing the expected volatility of the S&P 500 over a specific future period.
• ETN (Exchange Traded Note): A type of unsecured debt security issued by a financial institution. Unlike ETFs, ETNs do not hold physical assets but rather track an index or strategy through futures contracts.
• ETF (Exchange Traded Fund): A type of investment fund that holds physical assets or a basket of securities.
• Contango: A market condition where futures prices are higher than the spot price, or where longer-dated futures contracts are trading at higher prices than shorter-dated ones. This is the typical state of the VIX futures curve.
• Backwardation: A market condition where futures prices are lower than the spot price, or where shorter-dated futures contracts are trading at higher prices than longer-dated ones. This occurs during periods of high market stress.
• Roll Yield: The profit or loss incurred when a futures contract approaches expiration and is replaced by a contract with a later expiration date.
• Mean Reversion: The theory that asset prices and historical returns eventually move back towards their long-run average.
• Volatility of Volatility: The degree of fluctuation in the VIX itself.

VXX: Understanding the ETN and its Mechanics

The video discusses the VXX, an Exchange Traded Note (ETN) designed to track short-term VIX futures. It's crucial to understand that VXX is not a direct investment in the VIX index itself but rather in futures contracts related to it. Unlike ETFs that hold physical assets, ETNs are debt instruments issued by financial institutions.

Key Points:

• Tracking Mechanism: VXX tracks a rolling position in the front two monthly VIX futures contracts. This basket of contracts changes over time, and its composition has evolved, with a shift away from being heavily weighted towards the front contract.
• Short-Term Correlation: On a day-to-day basis, VXX exhibits a high correlation (median reading of around 0.9) with the VIX, meaning they tend to move in the same direction.
• Long-Term Divergence: Despite short-term correlation, the long-term performance of VXX is vastly different from the VIX. While the VIX tends to mean revert within a range (typically around 20), VXX consistently loses value over time.

The Drag Effect: Contango and Value Erosion

The primary reason for VXX's long-term value erosion is the "drag effect," which stems from its structure and how it manages futures contracts. This drag is distinct from the one found in leveraged ETFs.

Key Points:

• Futures Rolling: VXX continuously sells expiring front-month VIX futures contracts and buys the next month's contract. This process is known as rolling.
• Contango as a Headwind: The VIX futures curve is in contango approximately 80% of the time. In a contango market, front-month futures are cheaper than back-month futures. When VXX sells the cheaper front contract and buys the more expensive back contract, it incurs a loss on each roll.
• Compounding Loss: This loss from rolling in contango happens month after month, compounding over time and steadily dragging the value of VXX lower.
• Example of Contango: If the front contract is trading at 19.5 and the next contract at 20, VXX loses 0.50 (50 ticks) on each roll. This loss, when repeated consistently, significantly impacts the ETN's value.
• Historical Performance: A chart from January 2010 shows VXX trading at 8,000, but this is due to numerous splits that occur because the ETN would otherwise go to zero. Over a 5-year period, despite major market events like COVID and tariff tantrums, holding VXX would result in a loss of approximately 98%.

Backwardation: A Temporary Tailwind

In contrast to contango, backwardation can provide a temporary boost to VXX's value.

Key Points:

• Market Stress: Backwardation occurs when markets are stressed, and short-term futures become more expensive than longer-dated ones.
• "Selling High, Buying Low": In backwardation, VXX sells the more expensive short-term contract and buys the cheaper longer-term contract, leading to a value gain on the roll.
• Example of Backwardation: If the front contract is trading at 28 and the next contract at 26, VXX gains 2 points on the roll.

VXX as a Short-Term Trading Vehicle

Due to the persistent drag effect, VXX is not suitable as a long-term investment. It is designed as a short-term trading or hedging vehicle.

Key Points:

• Active Traders: VXX attracts active traders and speculators due to its high volatility.
• Short Duration: It is best used for very short durations, such as one day or one week, for speculative trades or as a hedge.
• Negative Returns: Average daily, weekly, monthly, and annual returns for VXX are negative, highlighting its unsuitability for buy-and-hold strategies.

Risks of Shorting VXX

While the majority of the time VXX trends downwards, taking the short side of this trade carries significant risks due to the potential for sharp, unexpected spikes.

Key Points:

• Volatility of Volatility: The volatility of volatility itself can expand, leading to amplified price swings.
• Overleveraging: Traders who overleverage their short positions may not be able to withstand these spikes, which can be much larger and more persistent than anticipated.
• Margin Requirements: Extended spikes can lead to changes in margin requirements, increasing the risk of a position.
• Impact on Options: Selling VIX calls or VXX calls can also be negatively impacted, as their volatility expands during these upward spikes, leading to losses on both aspects of the trade.

Conclusion and Takeaways

VXX is a complex financial product with specific characteristics that make it unsuitable for long-term investment.

Key Takeaways:

• ETN vs. Index: VXX is an ETN tracking VIX futures, not the VIX index itself.
• Contango Drag: The persistent contango in VIX futures creates a drag that erodes VXX's value over time.
• Short-Term Utility: VXX is best utilized as a short-term hedge or speculative trade, particularly during volatility spikes.
• Risk of Shorting: Traders taking the opposite side (shorting VXX) must be prepared to withstand potentially large and prolonged spikes in its price.
• Purpose of Products: Products like VXX, SQQQ, and TQQQ are often designed for fee collection and are not intended for long-term holding, which is where many investors encounter problems.