The Definitive Guide To Trading VXX [2019]

The Definitive Guide To Trading VXX [2019]

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VXX

The new guide will show you everything you need to know about VXX.

First, I’ll help you understand the basics of VXX.

Then, I’ll help you figure out how to trade VXX using options for your options trading portfolio.

Sound good? Let’s dive right in…

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1

VXX 101

In this chapter I'll show you exactly what you need to know on VXX. 


Then, I'll get into the details and explain a few concepts that will help you make better VXX trades.


Let's get started.

What is VXX?

Here’s the textbook definition of VXX:

VXX

VXX is an exchange traded note (ETN) that tracks the short-term VIX futures created by Barclays Bank

VXX is basically an index that tracks short term volatility. 

So, if market participants see future volatility increasing, VXX will increase. If market participants see future volatility decreasing, VXX will decrease.

This makes VXX inversely correlated with the overall stock market.

This is because stock market volatility is typically to the downside. If stocks drop, volatility increases due to the sheer magnitude of the moves down relative to the size of the moves up.

If you think that stocks might drop in the near future, you can simply buy “shares” of VXX just as you would buy shares of any stock or ETF.

If you think that stocks will increase in the near future, you can short shares of VXX.

Barclays Bank is probably not allowing you to trade short-term volatility for free…

In fact, Barclays charges a hefty 0.89% annual fee on the value of VXX for the ability to trade its products.

Barclays VXX

How Is VXX Valued?

So, how does VXX track short-term volatility?

Unlike stocks, where the value of the stock is determined partly by the fundamental performance of the company, ETNs like VXX is tied to the current value of the VIX.

But VIX is not a tradeable products so Barclays has to resort to something else.

VXX’s portfolio value is achieved by maintaining a portfolio of the front two months of /VX futures that are continuously rebalanced.

The VXX prospectus outlines how the ETN will actually rebalance the portfolio of /VX futures.

However, by tying the value of VXX to /VX futures, there is a hidden cost or drag to VXX due to contango in the /VX futures.

I’ll explain what contango is in a later chapter.

Since /VX is mostly in a state of contango, VXX will have to rebalance its portfolio for an increasing cost, causing the value of VXX to continually decrease over time.

ETFs vs. ETNs

So, what exactly is the difference between an ETF and an ETN?

ETFs vs. ETNs

An ETF is an exchange traded fund. This means the fund actually owns the underlying assets to achieve whatever investment goal the fund set out to achieve.


An ETN is an exchange traded note. The fundamental difference is that an ETF does not own any of the underlying assets. 

To get technical, an ETN is a structured product that is issued as senior debt notes.

Just like any other debt instrument, an ETN can be held to maturity, bought or sold at the market.

You can even trade options contracts on an ETN to bet on the future price of VXX (VXX options).

If the underwriter were to go bankrupt, the investors would risk a default on the note.

The benefit of using an ETN structure instead of an ETF is that there is no tracking error with ETNs. It’s the obligation of the underwriter of the ETN to match the performance of a certain index or strategy (/VX in the case of VXX).

Because VXX is an ETN, which is a debt instrument, the note is actually coming due in 2019. This means that investors who hold interest in the VXX note will receive a payout based on the note’s value.

So, what does this mean for VXX going forward?

After 2019, VXX will no longer exist, so you won’t be able to trade it going forward including VXX options.

However, Barclays is issuing a new ETN with ticker symbol VXXB.

VXXB is essentailly the same exact product as VXX, but with a further dated maturity.

So, you’ll be able trade short-term volatility as you always have with the new volatility product VXXB.

VXX Doesn’t Perfectly Track the VIX

You may think if VXX is a portfolio of /VX futures, they would move similarly.

It’s not that straightforward.

This is because VXX is based on a rebalancing algorithm of /VX futures, which are based on the call and put prices of the SPX (S&P 500).

Because they aren’t perfectly tracking products, VXX and VIX stay in sync about 80% of the time.

And on average, VXX moves only 45% as much as the VIX.

This makes makes VXX and VIX far from perfect substitutes.

But since there is no way to trade VIX itself, VXX is the best option that’s out there.

Volatility Contango

There is something very unique about VXX.

That is the fact that VXX is a constantly decaying asset.

This decaying nature is often referred to as “drag” by active traders.

VXX Chart

Some years, this drag has caused VXX to lose more than 50% of its value over the course of one year.

So, why does this happen?

It’s because the ETN has to constantly rebalance its portfolio of /VX futures.

Typically /VX futures are in a state of contango.

This means that further dated futures trade at a higher price than closer dated futures.

So, as the near dated /VX futures in its portfolio are expiring, the ETN has to go out to the /VX futures market to buy more /VX since that’s its whole purpose.

But, when the ETN goes out to buy more /VX futures at a further date, they have to pay more for the further dated future than the closer dated future they just sold.

This boils down to constantly selling stuff for cheap and buying stuff for expensive, which equals consistent losses over time.

Contango

A state of contango occurs when further dated futures trade at a higher price than nearer dated futures.

Here’s a concrete example:

Let’s say January /VX futures are trading at 10.75, February /VX futures are trading at 11.50 and March /VX futures are trading at 12.25.

(This is what I mean by a state of contango. The further out months trade at more expensive prices than the nearer dated futures.)

Let’s say I currently have a portfolio of 1 January and 1 February /VX futures. So, my current portfolio value is 22.25.

But January futures are expiring soon, so I need to roll from January to March.

To roll from one month to the next, I have to sell out of January and buy March /VX futures.

Here’s what that transaction looks like:

  • Sell 1 January /VX for 10.75
  • Buy 1 March /VX for 12.25

The net cost for this roll is -1.50. So, basically I just lost 1.50 of value from my portfolio because I had to pay for the roll.

After the end of the roll, my portfolio value is now only worth 20.75, which is a loss of 6% of my portfolio value.

This is the exact reason why VXX is constantly decaying in value.

VXX Reverse Splits

As you can see, VXX constantly decays in value.

If Barclays does nothing about it, the price of VXX would become pennies over the course of a year, making it nearly impossible to trade.

So, to combat the issue, they reverse split the ETN at a ratio of 4 to 1 if the price of VXX ever gets below $25.

Reverse Split

A reverse split occurs when the a company or underwriter of a traded products reduces the number of shares traded, thus increasing the per share value.

The reverse split increases the price of VXX temporarily, until it decays down to lower levels again.

2

Why Trade VXX?

So, now that you understand what VXX is and how it works, why would anyone want to trade VXX?


Fortunately, there is a valid reason why a trading vehicle like VXX exists.

 

And in this chapter, I’m going to lay out the few reasons why you may want to incorporate VXX into your trading portfolio.

 

Let’s dive in.

Hedge Your Portfolio With VXX

VXX is inversely correlated with the overall stock market.

What does this mean?

This means that if the stock market goes up, VXX typically goes down and vice versa.

This unique relationship between the stock market and VXX makes it a very good hedge for stock market uncertainty.

Hedge

A hedge is a trading strategy using to mitigate financial risk. It involves taking an opposite trade to where the risk lies in hopes of offsetting any potential losses.

The idea is that if you believe that stocks may selloff in the near future, you can buy shares of VXX for protection.

So, if your predictions come true, you will lose money on your shares of stock, but you will make up those losses because VXX will rise, producing a profit.

If you do it correctly, you can completely offset any losses you may incur during a market selloff with a VXX hedge.

Other options for hedging with volatility is using VXX options.

Instead of buying VXX directly, you can trade the VXX options.

If you wanted to hedge a long stock portfolio, you could potentially sell a put credit spread or buy a call debit spread, which gives you bullish exposure to VXX.

The risk with this hedging strategy occurs if you are wrong on the stock market sell off.

If the selloff never occurs, you will probably end up losing money on your VXX position because of the rampant drag associated with VXX as discussed in the earlier chapter.

Speculate on Volatility Using VXX

The second reason why you would want to trade VXX is due to speculation.

VXX is a liquid, two-sided market that allows you to make a calculated bet on where you think short-term volatility might go in the future.

If you think volatility is going higher in the future, you can take bullish positions on VXX through the underlying itself or VXX options.

If you think volatility is going lower in the future, you can take bearish positions instead.

However, don’t assume there is any edge taking one position over another in VXX.

The market is always happy to take your money no matter what side of the market you are on.

Since, VXX is a liquid product, it makes it possible to day trade the product if that is a strategy you use in your trading portfolio.

VXX options are also very liquid trading products, which makes it attractive to us since it allows us to make non-directional bets on the price of VXX and play time and volatility instead.

3

VXX Misconceptions

Now that you understand what VXX is and how to trade VXX and VXX options, let’s get into some misconceptions.


Since VXX is a pretty complicated trading vehicle, there are some common misconceptions that I’m going to debunk in this chapter.

 

Let’s get started.

1. VXX and VIX are the same

Newbie traders often confuse VXX and VIX, thinking that they are the same thing because they both are measures of market volatility.

As this blog post has already established, VXX is an ETN that carries a portfolio of /VX futures.

VIX, on the other hand, is an index that is based on a mathematical calculation of S&P 500 call and put option prices.

So, VIX measures volatility based on option prices of the S&P 500.

Because VIX is not a tradeable product, the only way to trade VIX is through /VX futures or VIX options (which are really /VX options just to make things even more confusing).

2. VXX and VIX have no relationship

Another common misconception about VXX is the exact opposite.

Another group of traders believe that VXX has no relationship with VIX.

The reality of the mystery of the relationship between VXX and VIX lies somewhere in between the first misconception and this one.

They are not the same thing, nor are the not the same thing.

They are different variations on one another.

Like stated earlier, VXX maintains a portfolio of /VX futures, so the tracking to VIX is similar but not the same.

One reason why newer traders believe they are completely different is because when you look at a chart of VXX, it seems to always go down due to the drag, while VIX does not.

VXX vs VIX

Also, there are days when VXX goes down (due to drag), while VIX goes higher causing this misconception.

3. If VXX has drag and always goes down, why not always short it

Here’s the question that I always get asked.

If VXX always goes down, why not just short it.

If it seems too good to be true, it probably is.

While yes, you can profit from shorting VXX due to the embedded drag, there is a huge risk to doing so.

Let me explain.

VXX has something called “takeover risk”.

It's the risk that VXX shoots up over 50% to 100% overnight due to a black swan event.

Black Swan Event

Traders typically define a black swan event as an unforeseeable or unprecedented event that causes massive volatility in the financial markets. 

It is honestly a matter of when it will happen, not if.

So, if you happen to be short VXX when a big volatility event occurs, you can expect to be out a lot of cash.

That’s why I never suggest to short VXX with undefined risk. It’s just not worth it.

However, using options spreads, you can created defined risk strategies that give you a similar payoff profile, without the risk of blowing out your trading account.

4

VXX Options

Okay, so now you have all this information about what VXX is and some common misconceptions associated with volatility products like VXX.


Now, I’d like to explain one way you can trade volatility using VXX options in a way that has a high probability of success.


Let’s get into it.

Volatility Options

VIX and VXX are both volatility products that have liquid, tradable options available. 

VIX options are little bit complicated.

Let me explain.

VIX options are actually based on the price of /VX futures.

So, if you ever look at VIX options for a January expiration, those options are actually priced on the price of January /VX futures, not VIX.

VXX options are simpler than VIX.

VXX options are based on the price of VXX.

If you have traded any type of options contracts before, this situation with VXX is no different.

VXX Option Strategy

So, as we have seen, VXX tends to move lower overtime due to the built in drag of the volatility product.

How can we safely take advantage of this?

The answer to that is to get short, or be bearish on VXX after a spike up in volatility.

Why does this work?

Because whenever there is a spike up in volatility, it tends to fall back down towards the average.

So, if you wanted to get short VXX you could use strategies like put debit spreads or call credit spreads.

Now, everyone in the market knows this fact, so there is no inherent “edge” by doing this.

It’s all priced into the options already.

But, it tends to work overtime so it’s a VXX option strategy worth looking into.

VXX Option Strategy Risks

What’s the risk with getting short volatility?

The risk that a black swan volatility event occurs and causes volatility to spike 50%+ overnight.

This is because volatility certainly has the capacity to do so.

So, how do you mitigate this risk?

The key is to keep your position size manageable and use defined risk.

Now It's Your Turn

So, that’s it for my guide to VXX.


I hope you enjoyed it.


Now I’d like to hear your take:


What types of things are you trading around VXX?


Or maybe you have a question about something from today’s guide.


Either way, let me know by leaving a quick comment below.

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