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Tracking Inacuracies of VXX


Explaining the confusion.


Opening up the Minyanville mailbag, a reader writes:

Can someone explain the apparent tracking inaccuracies of VXX ETF, VIX +1.65% while VXX -1% at the moment? Sure, I know ETFs don't always track well, but this is ridiculous.

While most of you were on the sidelines resting up for the playoffs, I was toiling away hours on end writing a piece for Barron's Striking Price on this very subject. Yes, I got the guest gig for the afternoon of December 31.

So please allow myself to quote -- myself:

In late January of this year, a VXX was born. That ETN tracks a perpetual 30-day VIX future, so thus it's a one-stop shop that always tracks the near term. It's still early, but on an average day, VXX tracks about 40%-50% of the move in the VIX itself. But alas, VXX has many issues. In order to maintain a constant 30-day duration, VXX needs to internally roll either VIX futures or swaps each and every day. By that I mean it must sell a short-term instrument and buy a longer-term one. If the VIX futures curve slopes upward (contango), that entails selling a relatively cheap nearer-term future or swap and buying a more expensive longer-dated future or swap. On a given day it's a small amount, but over and over again, it will really add up.

But it could work in reverse, right? What if the volatility-term structure slop/ed downward, that is, VIX futures traded progressively cheaper the further you went out in time. Wouldn't VXX benefit? The answer is presumably yes.

The problem is that's not how options tend to price. For the most part, the term structure slopes upward. Longer-dated volatility tends to trade more expensively than nearer term. The most notable exception occurred in 2008 when volatility in general spiked ferociously. VXX didn't exist yet, so it's unclear how it would have performed.

That's just the tracking problem. The bigger issue is of course that VIX futures themselves don't always track the VIX. They snapshot on a certain date, so a one-hour or even one-day VIX move may have little impact on the futures themselves.

Just a point also, on charting the VIX. Yes you have futures, and VXX. You can chart those too. They trade, they have supply/demand et. al. But keep in mind a few things: The VIX is the dog, they are the tail. As we just noted, there's no fixed relationship between VIX and VIX futures. A futures trade in the VIX will not get "arbed" against SPX options in any set way like SPX futures do versus SPX cash. Also, remember a VIX future will drift to the cash over time. So as such, I don't see where there's much value in charting a VIX future, it moves off the VIX itself, but in an uneven way. It's a derivative of a statistic based on derivatives.

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