What is VXX and How to Trade it?

In recent years, more and more traders have turned to VXX as a strategy for earning recurring income. But what is VXX exactly?

VXX is an exchange-traded note (ETN) that tracks the Volatility Index, also known as the VIX or “fear index.” This index measures expected market volatility over the next 30 days using S&P 500 index options. Essentially, VXX is a way for traders to bet on the market’s volatility levels.

In practice, this means that when the stock market is experiencing higher levels of volatility (i.e. big swings in prices), VXX will typically rise in value. Conversely, when the market calms down and volatility decreases, VXX generally declines.

How Does VXX Track VIX Futures?

So how exactly does VXX track the VIX index using VIX Futures? Well, it’s quite fascinating! VXX doesn’t directly invest in the VIX but instead utilizes the VIX futures market.

The ETN holds a rolling portfolio of the two nearest-to-expiration VIX futures contracts. Each day, a portion of the near-term contract is sold and the next-term contract is bought to maintain the one-month maturity exposure.

This daily rebalancing act is what allows VXX to mimic the performance of VIX futures, giving traders exposure to volatility without having to navigate the complexities of the futures market directly.

But here’s something to ponder over – what happens when the longer-dated VIX futures are more expensive than the shorter-dated ones? Keep this question in mind as we’ll delve into it in the next section.

The Contango Effect of VXX

The phenomenon we mentioned earlier is known as ‘contango.’

What does contango mean for traders who buy VXX? And why does it make buying VXX less than ideal?

Contango occurs when the futures prices are higher than the spot price. In the case of VIX futures, it means the longer-dated VIX futures are more expensive than the shorter-dated ones.

Because VXX holds and rebalances a mix of these futures contracts daily, when the market is in contango, it’s forced to sell the cheaper near-term contracts to buy the pricier next-term contracts. Imagine consistently selling low and buying high every day.

Sounds like a tough way to make a profit, right? This persistent roll-over cost can cause a significant drag on VXX’s performance over time, making it a less desirable long-term hold. Therefore, while VXX can be a handy tool for betting on short-term market volatilities, its susceptibility to the contango effect can make it a tricky play for long-term investments.

So, does it mean you should steer clear of VXX completely? Not necessarily – but we’ll discuss that in the next section!

Shorting VXX for Recurring Profit

Here’s where it gets interesting. Although the contango effect makes VXX a questionable choice for long-term investments, it presents a golden opportunity for traders to profit by shorting VXX.

Let’s take a hypothetical scenario to understand how shorting VXX could be profitable, especially in a contango market condition:

1. Start of the Trade: Let’s say Mike shorts VXX when it’s at $50, believing the market is in contango and VXX will decline over time due to roll-over costs. Essentially, Mike borrows shares of VXX and immediately sells them in the open market at the current price.
2. Market in Contango: As predicted, the market stays in Contango for the next several weeks. The VIX futures that VXX holds are continually bought at higher prices and sold at lower ones, causing a decline in VXX’s value.
3. VXX Price Drops: After a few months, let’s say VXX’s price has dropped to $45 due to the contango effect.
4. Closing the Short Position: Mike decides to close his short position. To do that, he buys back the VXX shares at the lower price of $40 in the open market and returns them to the lender.
5. Profit from the Trade: The difference between the price at which Joe initially sold the borrowed shares ($50) and the price he later bought them back at ($45) is his profit. In this case, Joe made a profit of $5 per share by shorting VXX.

While this might sound like a dream come true, remember, this is a simplified example and actual market conditions can be far more volatile and unpredictable.

Shorting VXX could be very risky thus trading VXX options would be a more sensible approach for traders who believe in the market’s volatility to decrease over time.

High Negative Correlation between VXX and S&P 500

One way to predict VXX is to monitor the S&P 500.

VXX tracks the performance of the S&P 500 VIX Short-Term Futures Index, which essentially measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

When the market is calm and stable, the S&P 500 typically goes up while the VIX goes down and hence VXX also goes down.

However, in times of market fear and uncertainty, the S&P 500 usually drops, while the VIX and VXX rise.

This inverse relationship is what creates a strong negative correlation between the S&P 500 and VXX. It’s like a see-saw; when one side goes up, the other must go down.

What Options Strategy to Use for Trading VXX Options?

When it comes to trading VXX options, a variety of strategies can be employed based on your risk appetite, market outlook, and investment goals.

Here are a few examples to consider:

1. Buy Calls: Betting on an increase in volatility, you could buy VXX call options. This strategy allows you to profit from surges in VXX without having to own the underlying asset.
2. Buy Puts: If you anticipate a decrease in volatility, buying VXX put options can be a smart move. It gives you the right to sell VXX at a predetermined price, allowing you to profit if VXX declines.
3. Protective Puts: This strategy involves buying VXX shares and simultaneously purchasing put options as an insurance policy. It limits your downside risk if volatility suddenly spikes.
4. Iron Condor: For those anticipating a range-bound VXX, an iron condor strategy could be ideal. It involves selling a call spread and a put spread on VXX, limiting your risk and profiting from low volatility.

Please note these are provided as examples and do not necessarily represent how I trade VIX and VXX options.

Compare VIX and VXX Options

How to Trade VXX with Options?

VXX can be bought and sold just like a stock. It also has options that we could trade. I typically do not trade VXX in anticipation of its price going up (only once in a while). Some people use VXX to hedge a market downturn, but this must be done with very accurate timing. As mentioned earlier, holding on to VXX is a guaranteed way to lose money due to the contango effect.

Below is a list of ways to trade VXX options to profit from its price decline. Obviously, there are pros and cons for each, so let me explain and add a bit of my experience for the ones that I have traded with VXX options.

• Buy Put Options
• Buy Put Spread
• Sell Naked Call Options
• Sell Call Spread
• Sell Call Back Ratio Spread
• Buy Call or Put Calendar / Diagonal Spread
• Buy Call or Put Butterfly / Broken Butterfly Spread

1)    Buy Put Options

My Personal Take on Buying Put Options

This is as simple as it gets. Buy put options to profit when the VXX price drops below the strike price.

However, Implied Volatility (IV) is typically very high when VXX price spikes so you would be buying additional premium and loss that when IV drops, which happens as VXX price drops.

Put Options

Pros of Trading Put Options to Profit from VXX Price Decline

• Limited risk: The maximum risk when buying put options is limited to the premium paid for the options contract. This means that even if the VXX price does not decline as expected, your potential loss is limited to the initial investment.
• Leveraged returns: Options contracts provide leverage, allowing you to control a larger amount of VXX for a fraction of the cost. This amplifies the potential returns if VXX declines as anticipated.

Cons of Trading Put Options to Profit from VXX Price Decline

• Time sensitivity: The VXX price needs to decline sufficiently and within a specific timeframe for the put options to be profitable. If the decline does not occur within the expected timeframe, the options may lose value or become worthless, resulting in a loss. There are other options strategies that could profit from time decay even if VXX price doesn’t move much.
• Higher cost: Compared to other options trading strategies, buying put options involves the upfront payment of the premium. The cost of purchasing options can be higher compared to alternative strategies, such as selling options or employing more complex strategies, which will be discussed later.
• Volatility impact: When VXX spikes, typically IV is very high. Changes in IV can affect the value of options. The decline in the VXX price is accompanied by a decrease in volatility generally speaking, so the value of the put options may not increase as expected, potentially reducing profitability.

2)    Buy Put Spread

My Personal Take on Buying Put Spread

While this strategy will help cancel most of the IV premium issues that we saw with buying Put options, one of the reasons I don’t trade this strategy very often with VXX is that the profit curve is not as sensitive compared to some other strategies.

Put Spread

Pros of Trading Put Spread to Profit from VXX Price Decline

• Limited risk: Buying a put spread limits your potential loss to the premium paid for the spread. This defined risk can provide a level of protection compared to simply buying a single put option.
• Lower cost: Buying a put spread involves simultaneously buying and selling put options with different strike prices. This helps offset the cost of the trade by collecting a premium from the sale of the higher strike put option.
• Lower sensitivity to volatility changes: Compared to a single long put option, a put spread is less sensitive to changes in implied volatility. This can be advantageous if volatility levels fluctuate during the trade.

Cons of Trading Put Spread to Profit from VXX Price Decline

• Limited profit potential: Buying a put spread limits your potential profit compared to owning a single put option. The profit potential is capped at the difference between the strike prices minus the net premium paid. This means that if the stock price declines significantly beyond the lower strike price, your potential profits may be limited.
• Breakeven point: The breakeven point for a put spread is higher compared to owning a single put option. To start profiting from the trade, the underlying asset price needs to decline beyond the breakeven point, which is the lower strike price minus the net premium paid. This may require a more substantial move in the stock price compared to a single-put option.
• Higher transaction costs: Buying a put spread involves both buying and selling options contracts. This can lead to higher transaction costs compared to purchasing a single-put option. It’s essential to consider the impact of commissions and fees on the overall profitability of the trade.

3)    Sell Naked Call Options

My Personal Take on Selling naked call options

I used to love this strategy because I could open very small positions with great profit potential. However, after getting assigned several times way before expiration (even though it was still a few weeks until the expiration because VXX was deep in the Call strike price, the call options holder decided to execute), and got margin calls when VXX price spiked up against my positions, I vowed not to trade naked call options again. EVER!

Naked Call

Pros of Trading Naked Call Options

• Income generation: Selling naked call options allows you to collect premium income upfront. As the seller, you receive the premium from the buyer of the call option. If the option expires out of the money (OTM) and is not exercised, you keep the premium as profit.
• Time decay advantage: As time passes, the value of options tends to decrease due to time decay. When you sell naked call options, you benefit from time decay working in your favor. If the underlying stock price remains below the strike price of the call option, the option may expire worthless, allowing you to retain the premium received.
• Volatility impact: When VXX spikes, typically IV is very high. Selling Call options also means selling volatility premium, which typically collapses as VXX drops in price.

Cons of Trading Naked Call Options

• Unlimited risk: Selling naked call options exposes you to unlimited risk. If the VXX price rises significantly above the strike price of the call option, you may incur substantial losses. The potential loss is theoretically unlimited since the VXX price can continue to rise indefinitely.
• Margin requirements: Selling naked call options may require you to maintain a margin account with your broker. Depending on the specific requirements and regulations, you may need to maintain a certain level of margin or collateral to cover potential losses. This can tie up capital and increase leverage, which may not be suitable for all traders.
• Obligation for potential assignment: When you sell naked call options, there is a possibility of being assigned if the buyer decides to exercise the options. This means you would be shorting VXX after getting assigned and could cause a margin call if you have a small account. It’s important to be prepared for potential assignments and have sufficient capital or a plan to handle the obligation.

4)    Sell Call Spread

My Personal Take on Selling Naked Call Spread

While this is much safer than selling naked call options, I don’t like the possibility of getting assigned on my short call option. It’s protected by the long call option, but I just don’t like the feeling.  I could achieve the same profit profile by buying Put Spread instead, which is much safer in my opinion.

Call Spread

Pros of Trading Call Spread

• Limited risk: Selling a call spread involves simultaneously selling a call option with a lower strike price and buying a call option with a higher strike price. This strategy limits your risk to the difference between the two strike prices minus the net premium received. The defined risk allows for better risk management compared to selling a naked call option.
• Income generation: By selling a call spread, you receive a premium upfront from the buyer of the options. This premium is yours to keep as profit if the options expire out of the money (OTM) and are not exercised. The income generated from selling the spread can be used to offset other trading costs or as additional income.
• Time decay advantage: As time passes, the value of options tends to decrease due to time decay. When you sell a call spread, you benefit from time decay working in your favor. If the underlying stock price remains below the lower strike price, both options can expire worthless, allowing you to keep the full premium received.

Cons of Trading Call Spread

• Limited profit potential: Selling a call spread comes with a limited profit potential. The maximum profit occurs when the underlying stock price remains below the lower strike price at expiration. As the stock price approaches or goes above the higher strike price, the potential profit decreases.
• Potential for assignment: Although less likely compared to selling naked call options, there is still a possibility of being assigned if the buyer decides to exercise the options. If the short-call option is assigned, you would be obligated to sell the underlying stock at the strike price, even if it is lower than the current market price. It’s important to be prepared for potential assignments and have sufficient capital or a plan to handle the obligation.
• Limited upside potential: When you sell a call spread, you cap your potential profit and give up the opportunity to fully participate in any substantial upside movement of the underlying stock. If the stock price rises significantly above the higher strike price, your potential profit is limited to the premium received.

5)    Sell Call Back Ratio

My Personal Take on Selling Back Ratio

The most basic form of this is a 2:1 ratio of selling two naked call options and buying one call option.  It can be modified to a 3:2 ratio, 5:3 ratio, etc. Compared to just selling naked call options, it adds protection by buying call options. As a result, the margin requirement is a little lower compared to just selling naked call options, and depending on the strike prices, the velocity of loss could be slowed up until a chosen price point. However, it is still an unlimited loss strategy.

Call Back Ratio

Pros of Trading Call Back Ratio

• Transaction Cost: You can potentially achieve the same profit target by trading with a smaller position size compared to some of the other strategies. However, that does not mean you are risking less because this strategy is practically the same as selling naked call options.

Cons of Trading Call Back Ratio

• Unlimited risk on the upside: Like selling Naked call options, there is an unlimited risk if VXX price goes up.
• Margin requirements: Like Selling naked call options, depending on the specific requirements and regulations, you may need to maintain a certain level of margin or collateral to cover potential losses. This can tie up capital and increase leverage, which may not be suitable for all investors.

6)    Buy Call Diagonal Spread

My Personal Take on Buying Call Diagonal Spread

This could be a strategy to profit from underlying asset price drop but ideally, the position should be opened when implied volatility is relatively low because IV of the back month options tends to be higher than the front month (Higher Vega). So for example, trading this strategy with SPX or NDX could be profitable because when their price drops, IV tends to increase.

However, opening this spread when the VXX price spikes up is not ideal because the IV of VXX options tends to spike when the VXX price spikes so you are essentially buying the high IV, then losing that IV value as the VXX price drops. I am listing this just as one of the trading strategies to consider but do not recommend it personally.

Call Diagonal Spread

7)    Buy Call or Put Butterfly Spread / Broken Butterfly

My Personal Take on Buying Call or Put Butterfly Spread / Broken Butterfly

For a butterfly spread, while it requires very little capital to open with huge upside potential, you would need to know exactly where the price will end up at expiration. The real profit will not kick in until the week of expiration so almost no profit can be made when the position is closed earlier than the expiration date.

A broken butterfly spread, on the other hand, can be structured to profit even if the price at expiration does not fall exactly where it was predicted. It is also a limited loss strategy so unlike naked options strategies, this is a much safer way to speculate.

The downside is a much larger transaction cost because we are essentially opening multiple legs of Call spreads or Put spreads to create the butterfly structure.

I personally prefer to trade Put Broken Butterfly rather than Call Broken Butterfly because of the potential for assignment if the short-call leg happens to be in the money.

Butterfly Spread

Broken Butterfly Spread

Pros of Trading Call or Put Butterfly Spread

Limited risk: The risk in a Buy Put Broken Butterfly Spread is limited to the net premium paid for the spread. This predefined risk allows for better risk management and protects against substantial losses in the event of adverse price movements.

Cost-effective strategy: Compared to buying a single put option, the Buy Put Butterfly Spread can be a more cost-effective strategy. It involves purchasing and selling multiple put options with different strike prices, which can help reduce the overall cost of the trade.

Versatility in market scenarios: The Buy Put Broken Butterfly Spread can be a versatile strategy that offers profit potential in different market scenarios. It can be profitable if the stock price remains close to the middle strike price at expiration, providing an opportunity for profit in a range-bound market.

Potential for limited loss or breakeven: Even if the trade does not result in a significant profit, the Buy Put Butterfly Spread has the potential for limited loss or even a breakeven outcome. This can be advantageous compared to other strategies that may incur larger losses in unfavorable market conditions.

Cons of Trading Call or Put Butterfly Spread

Higher transaction costs: Implementing a Put Broken Butterfly Spread involves buying and selling multiple options contracts, which can lead to higher transaction costs compared to simpler options strategies. These costs can eat into potential profits.

Narrow profit zone: The profit zone for a Call / Put Butterfly Spread is relatively narrow. The stock price needs to be within a specific range around the middle strike price at expiration for the strategy to be profitable. If the stock price moves significantly beyond this range, the profitability of the trade may be limited. However, this does not always apply to Broken Butterfly spreads.

Sensitivity to volatility changes: Changes in IV can affect the value of options in a Call or Put Butterfly Spread. If there is a significant change in volatility levels, it can impact the profitability of the strategy, notably if the volatility decreases. While this is a significant downside, it is not a large enough deal in my opinion based on the way I trade VXX options.

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Tony

I have been trading options since 2010 and have been testing and experimenting with various trading styles. Fundamental Analysis based, Technical Analysis based, Trend Following, Day Trading, Swing Trading, etc.

My primary option trading strategies incorporate volatility and I am constantly experimenting with various trading strategies to improve my PNL.

I hold two Master’s degrees (MSc and MBA) with career experience as a cancer research scientist and a digital marketer.

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