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

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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.

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Easy Conclusion
  • Avoid it like the plague. If it walks like a duck, quacks like a duck, and looks like a duck, it probably isn't a chicken. – JD
  • If it doesn't look like it hedges volatility it probably doesn't.
Wind at Your Back Method – Declining Volatility

One simple tactic that I have used is when I expect a decline in volatility and/or a rise in the general stock market, I look to short the VXX ETF knowing that the prescribed "decay" affect will actually aid the positions possible performance over time. I have also tested bearish call spreads using option leverage for the same affect. After examining the use of puts, I have concluded that this "decay premium" is often priced in and generally does not seem like the most efficient way to make a bearish speculation.

Free Money Arbitrage

Lastly, I want to leave you all with an outline of a trading strategy that I have been testing for about one year now and am currently trying to optimize. My initial reaction to this Eureka! moment I had about this time last year was to just short the correlation/covariance adjusted spread between the two (short VXX shares and long CBOE VIX futures contracts in perpetuity).

This simple spread trade was relatively successful but has made me gradually gravitate towards options writing strategies that could possibly provide less risk and potentially higher rewards. Other tested strategies have included short diagonal call calendar spreads in the VXX and short naked calls in VXX that are hedged with long CBOE VIX calls, the latter being an extremely risky strategy due to the naked short call position in the VXX. This combination, albeit risky, was very profitable during the Sept 2012 to Nov. 2012 period because the VXX calls expired worthless and the VIX calls I purchased ended up in the money. However, I believe this to be a rare occurrence.

Beware!

I have gone back and looked at every period of comparison for the VXX and the CBOE VIX and there are certain periods of time that the VXX will actually outperform the VIX. Note that this out performance normally does not extend past 60-90 days. Additionally, since there is not that much historical data for statistically significant comparison and I would also take note that this analysis is bordering on uncharted territory and cannot be assumed to hold in the future till more time passes and data is added to the comparison.

Optimization

Additionally, I am also attempting to apply a ratio adjustment component to how many VXX shares / call options I weight short vs. VIX futures / call options I weight long based on the slope of the VIX futures curve and the sustained duration of a specific slope. This analysis has proven quite complex and difficult to confirm so its still under construction.

Russell Rhoads @RussellRhoads of the CBOE Options Institute, is the Grand Master of the CBOE VIX and has provided me statistics that put the CBOE VIX in contango approximately 75% amount of the time since 2007. So I would expect the decay to be effective 75% of the time or more. The goal of optimization would be to know when an advantageous time to apply higher amounts of leverage to the spread given the probability of the curve staying or steepening in contango.

Editor's note: This article originally appeared on investing and economics site, See It Market.
Position in VXX call options and CBOE VIX options.
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