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Advanced Trading: Exposing the VXX to Understand Volatility Contango and Time Decay


A deep dive into the VXX volatility: How the dynamic allocation and active rebalancing of the VXX creates a trading vehicle to take advantage of declining volatility and/or even a rising/flat stock market.

I have been analyzing this market anomaly for some time now and am glad to be able to showcase my findings here.

For those of you who are not familiar with the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), I want to briefly outline what it is and why I think it is something to pay attention to if you are an active trader.

Below is a description of the VXX ETF found on the iPath Website:

The S&P 500 VIX Short-Term Futures Index TR is designed to provide access to equity market volatility through CBOE Volatility Index (the "VIX Index (^VIX)") futures. Specifically, the S&P 500 VIX Short-Term Futures Index TR offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract.

It is my opinion that this dynamic allocation and active rebalance of the VXX creates a trading vehicle that can be of great assistance when you are looking for a trade to take advantage of declining volatility and/or even a rising/flat stock market. This is because the VXX has a decay effect that is very consistent and significant over time and is more pronounced as long as the CBOE VIX futures curve remains in "contango."

Here's the Problem

Every month the VXX suffers from negative roll yield when the CBOE VIX futures curve is in contango. The VXX Fund must "roll" its futures to rebalance 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 rebalancing.

You can always see what the shape of the VIX futures curve is directly from the CBOE website.

You can also see the VXX current allocation at any time on the iPath website.

This decay, like the slow leak of a tire (which I call "the death drip") has been, and continues to be, very significant over long periods of time, especially in prolonged periods of VIX Term structure contango. Below are some charts illustrating this effect:

Click to enlarge

Since Inception 2009-01-29 the VXX is down 98.02% while the VIX is only down 65% over the same time period.
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Position in VXX call options and CBOE VIX options.
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