By: Steve Smith
My big, and not so bold, prediction for 2018 is the VXX will hit new all-time lows. Thanks to the latest 4-1 reverse split, iPath S&P 500 VIX Short-Term (VXX) currently trades at a seemingly healthy $27 per share. But this volatility-based ETF has undergone its fifth 4-1 reverse stock split. Meaning, on a pre-split adjusted basis, the stock has declined from $120,000 for a 99.9% loss over the past seven years. It’s not the most contentious options trading advice to treat this ETF with some skepticism.
And furthermore, there’s little doubt that it’s destined to decline another 99% from current levels, and be forced into another reverse split.
One would think that any security that has declined 99% since it was launched years ago would be not only be greeted with disgust by investors, but would also face a de-listing. Instead, the iPath S&P VIX (VXX) has only seen its popularity soar. In 2011, the VXX’s average daily trading volume was 10 million shares. Last year it went up to 25 million shares a day. That’s higher than 85% of the stocks listed in the S&P 500 Index.
Thanks to the very nature of its construction, it will ultimately drop another 99% over the next few years. And because volatility is simply a statistic and will never go away, neither will the VXX. It is the gift that will keep giving.
Before getting to the specific options trading strategy, a little background on the nature and nuances of these products are in order to make sure we understand statistics and structure the drive the behavior of securities and options tied to implied volatility.
The Chicago Board of Options Exchange created its VIX Index back in 1992, as a means of measuring the 30-day implied volatility of options on the S&P 500 Index. The goal was to provide a snapshot of how much people were willing to pay during options trading, as an expression of expected price movement of the broad market. It was quickly given the “fear gauge” moniker, given VIX tends to rise during market sell-offs. During those periods, investors are willing to pay higher premiums to protect their portfolios.
But it wasn’t until 2004, when futures contracts based on the index were launched, that one could actually trade the well-known futures. Those were subsequently followed in 2009 by Exchange Traded Notes such as iPath S&P 500 VIX Short-Term (VXX) and the Velocity Shares 2x VIX Short Term (TVIX) and their related options.
The timing of the 2009 launch was both fortuitous and unfortunate. It was fortuitous for exchanges such the CBOE and issuers such as Barclay’s, as this new “asset class” for hedging has become wildly successful in terms popularity, assets under management and trading volume.
But for uninformed investors that thought they could own these as long term hedges, VIX-related ETFs have been an unmitigated disaster.
Barclay’s acknowledges as much in the security’s prospectus, saying that “due to the construction for this product, one needs to be aware that its value will approach zero over time.”
So what the heck is going on here? To understand what’s at work, we need to look at how volatility is reverting to the mean. Futures trade at a premium. Roll means buying high and selling low on a daily basis. This creates a headwind on the price, dragging it lower over time.
As we’ll see, these can be tricky to trade, and are best used for shorter time frames. Basically, VXX is a chimera; it’s structured like a bond, trades like a stock, follows VIX futures, and decays like an option. But once we understand some of the basic concepts behind this sort of options trading, they can be used for fairly predictable profits.
Some important points:
- The VIX is mean reverting statistic. Its 20-year mean is 18.8.
- The VIX “cash” Index cannot be traded directly.
- The daily change in VIX has had a -0.76 correlation to the daily change in SPY since Jan. 30, 2009. Meaning every $1 change in the SPY the VIX will move inversely by approximately 0.75.
- On average VXX moves only 55% as much as the VIX index.
- The VXX will lose at the average rate of4% per month (30% per year) Ceteris paribus. All else being equal.
This last item, that is the downward drift is in the value of VXX, is what we want to focus on for harnessing profits in options trading.
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 re-balanced; that is, it must 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.
Contango Towards Zero
The term structure in normal volatility environments is 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 contango term structure can be seen here:
Note the highlighted contango premium of front month which currently stands at 9%. All else being equal, this is amount one could expect shares of VXX to decline during the next 30 days simply due to the headwind of its structure.
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 re-balance 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 re-balancing.
There are some periods when volatility spikes higher and the near term futures will trade at the premium to the later dates on the; this is known as ‘backwardation.’ It is based on the notion that at some point in the future volatility will subside back to normal levels. Again, the concept of VIX being mean reverting.
And that means one can expect the VXX to hit new lows. Again and again.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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