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.