Every knows volatility related Exchange Traded Notes such as iPath S&P 500 VIX Short-Term (VXX) have a construction that creates a headwind and sends their value towards zero over time. But many a man has gone mad, or broke, trying to find a way to short it in a way that will produce decent profits on a consistent basis without too much risk.

Lo and behold, while I have not discovered the holy grail, I may have hit on strategy giving us a low cost, limited risk way to ride the tailwind of the rolling decay that inflicts the VXX.

Before getting to the specific strategies a little background on the nature and nuances of these products are in order to make sure we understand statistics and structure driving the behavior of securities and options tied to implied volatility.

The Chicago Board of Options Exchange created the VIX Index back in 1992 as a means of measuring the 30-day implied volatility of options on the S&P 500 Index. But it wasn’t until 2004, when futures contracts based on the index were launched, that one could actually trade the well-known Futures. These were subsequently followed in 2009 by Exchange Traded Notes such as the iPath S&P 500 VIX Short-Term (VXX) and Velocity Shares 2x VIX Short Term (TVIX) and their related options.

The timing of the 2009 launch was both fortuitous and unfortunate; the former for exchanges, such the CBOE and issuers such as Barclay’s, as this new “asset class” for hedging have become wildly successful in terms popularity, assets under management and trading volume.

But for uninformed investors who thought they could own these as long term hedge, VIX related ETPs have been an unmitigated disaster.

For example, the VXX has declined by 99.6% since inception as its shares, which have undergone five 4:1 reverse splits, have sunk from $32,000 to the current $36 on a split adjusted basis. That’s some $5 billion in value that’s been vaporized.

Cantango Towards Zero 

The VXX’s goal is to maintain a 30-day measure of implied volatility. Since it can’t own “cash” VIX is constructed through the purchase of futures contracts. It uses a balance of the front two month contracts. Each day it must be rebalanced, that is sell some of the front month and buy some of the second month to maintain the 30-day weighting. This is where it gets good.

The term structure in normal volatility environments one in which later dates trade at a premium or higher prices. This is known as contango and comes from the notion that given a longer period of time the higher the probability of large price change or increase in volatility.

A normal cantango term structure can be seen here:

Under these circumstances VXX suffers from negative roll yield when the CBOE VIX futures curve is in contango. Each day the VXX Fund must “roll” its futures to rebalance to the later contract and as the expiration date nears, it is forced to sell its closest to expiry contracts and buy the next dated contracts. The purchases are often at higher prices if the curve is in contango, thus losing the spread amount between the two contracts that are rebalancing.

The result and key to our trade is: the VXX will loss at the average rate of 4% per month (30% per year. All else being equal (Ceteris paribus).

Trade One: Catch the Drift

Now, given the above one might ask, “why can’t I just short the VXX or sell calls, sit back and watch them go down?”

The issue is when volatility spikes in volatility, which it does inevitably and unexpectedly 3-4 times a year, the move tend to be vicious with 30%-50% increases within a matter of days out not out of the ordinary.

That might work for an institution that can do some sophisticated multi-market hedging or a deep pocketed investor with a high risk tolerance who could ride out the pain but for most of us such a move could a create a loss wiping out several expiration cycles of gains.

Also, the “rolling decay” is well known and priced into the options. For example if $2 wide call spread is valued at only 50c while its mirror put spread would be worth approximately $1.20.

The conclusion being this “Decay Premium” is priced in and generally speaking basic vertical spreads are not the most efficient way to make a bearish speculation.

My approach is to use a butterfly spread as a lower cost, higher reward way to target the expected drift lower.

• A standard butterfly spread uses a 1x2x1
• On a long butterfly you buy the outside or “wings” and sell the middle strike or “body.”
• The maximum profit is realized if shares of the underlying at the middle strike on expiration.

Based on the knowledge the VXX can be expected drift approximately 4%-5% lower per month all else being equal I want to target the $33 level (a 10% decline from the current) in 60 days.

Currently with the VXX trading around $37.30 the specific trade would look like:

-Buy 10 contracts October 36 Put

-Sell 20 contracts October 33 Put

-Buy 10 contracts October 30 Put

For a $0.35 Net Debit or $350 for the 10x20x10 contract position.

As you can see from the risk graph below the maximum loss is the cost ($350) and would be incurred if VXX is above $36 or below $30 at the October expiration.

The maximum profit is $2,650 and would be realized if shares are at $33 on expiration.

The presents us with a very attractive 7.5x profit to risk ratio.

Now, it is unlikely VXX will be exactly at $33 on expiration but given the known downward directional bias there is a high probability that it be within the profit zone of $30.40 and $35.70.

And given the attractive risk/reward profile this a strategy when can repeat on a three to four week expiration cycle on the expectation that over time the downward drift of the VXX will land you in the profit zone more often than not.

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