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What Is VXX And How Does It Work?

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by Gavin in Blog
June 24, 2020 0 comments

You might have asked yourself “What is VXX?”. Well, today we’re going to answer that question and more.

Contents

Introduction

The VXX is a special type of asset called an Exchanged Traded Note (ETN) and it tracks the S&P500 VIX short-term futures.

Due to its unique nature, it has several characteristics that make it different to most assets that investors are familiar with.

For example, one of the characteristics of the VXX is that over time, the price will tend to decay towards zero. This is especially true when the VIX futures curve is in Contango.

Another characteristic is that it functions somewhat like a bond and pays the return of the index at maturity, but does not pay interest.

While these characteristics may seem odd or even negative, there are benefits to using the VXX in your trading.

Since the VXX is quite unique, it’s important to develop a solid understanding of what it is and how it works, before you decide to trade it.

What Is VXX?

The VXX is short for the iPath Series B S&P 500 VIX Short-Term Futures ETN.

It was created by Barclays as a way to enable traders to make bets on changes in short-term volatility.

There are two important components to the VXX that this article will explore.

The first is that it is an ETN so it has different characteristics to most securities investors are familiar with.

The second component is that it tracks the S&P500 VIX Short-Term Futures, so understanding what this is will help you to determine if the VXX has a place in your investment strategy.

We’ll start by covering the first component of what an ETN is and how it works.

Exchange-Traded Notes

As an ETN, the VXX functions as a type of bond, however one that does not pay any interest payments.

It tracks an underlying market index (in this case, VIX futures) and since it is exchanged traded, it means that investors can buy or sell it just like they would regular stocks and can take advantage of rising and falling prices.

ETNs are sometimes mixed up with Exchange Traded Funds (ETF), however despite both being exchanged traded, fundamentally they are very different.

With an ETF, any securities it tracks are also owned by the ETF, so owners of ETFs own the underlying securities as well.

So for example, if you were to buy an ETF that tracks the S&P 500, you would also be buying an ownership stake in all of the 500 stocks that make up the S&P 500 index.

An ETN differs from an ETF in that it does not provide ownership of the underlying securities it tracks.

In the case of the VXX, this means that when an investor buys it, they don’t have any ownership rights for the futures contracts that it tracks.

In a way, they function very similar to a standard debt security and investors buying the VXX have to trust the issuer, Barclays, that they will deliver as promised, a return based on the underlying index.

We’ll now cover the second component of the VXX which is the underlying security it tracks – the S&P 500 VIX short-term futures. 

S&P 500 VIX Short-Term Futures

The S&P 500 VIX Short-Term Futures is an index that is made up of the two VIX futures contracts that are nearest to expiration (that is to say, the front two-month VIX futures).

VIX futures are a way for investors to profit from volatility as measured by the VIX, which is a calculated index that is designed to show the 30-day expected volatility of the U.S. stock market.

Since the VIX is a calculated index, there is no actual VIX asset that can be directly traded by market participants.

So when Barclays created the VXX they relied on the next-closest thing to the VIX, being VIX futures.

The weighting of the two VIX futures contracts changes every day, such that each day will bring a new mix of the amount of VIX futures in the portfolio.

This changing mix, coupled with the use of VIX futures which are a derivative of the VIX, means that the VXX does not track the VIX completely accurately.

In fact the VXX will move, on average, by only 45% of the corresponding move in the VIX.

This dynamic does however present some good opportunities on occasion such as during backwardation, which is a time when the back month future is worth less than the front month future.

In this scenario, the VXX would outperform the VIX and can generate nice profits for astute traders.

How VXX Works

Since the VXX uses short-term VIX futures, it is best to think of it as a way of trading fear (volatility) in the market.

For example, during the Global Financial Crisis of 2008, the VIX soared by more than 700% as fearful investors rushed to liquidate holdings and cashed-up value investors pounced on once-in-a-lifetime buying opportunities.

Due to the way that that VIX soared, investors quickly become interested in finding ways to profit from it.

As the VIX is a market index and not a tradable security, products like the VXX were developed.

Being exchanged-traded and tracking the VIX (somewhat), the VXX is both liquid enough and close enough to the actual VIX gauge for traders to use as a means for profiting from volatility.

That being said, the VXX has a specified maturity, which means that on the maturity date, investors that are holding shares in the VXX will receive a final payment based on its net asset value.

The nature of having to continually rollover contracts from one month to the other, means that over time, the value of the VXX will decline.

It is for this reason that the VXX prospectus warns that “if you hold your ETNs as a long-term investment, it is likely you will lose all or a substantial portion of your investment”.

As the chart below shows, in the last two years despite a number of spikes during short term periods of market fear, the VXX has been in a continual downward trend.

what is vxxSource: Yahoo Finance

As a result, the VXX is best used only during very brief, short-term periods where intense market fear raises stock market volatility.

It’s worth noting that spikes can come on very fast and reach very high levels, even more than historic norms so exercise caution if shorting the VXX.

When reviewing some of the historic VXX data yourself, you might notice some oddities which have been driven by the constant march towards the maturity date.

Barclay’s first VXX product was launched in 2009, with a maturity date set in January 2019.

As the maturity date was approaching and the product would expire, Barclays launched a second offering called the VXXB in January 2018.

Once VXX expired in January 2019, shortly afterward VXXB was renamed to VXX in May 2019.

There are two main differences between the new VXX (Formerly VXXB) and the original:

  • The maturity date has been changed to 30 years, compared to the original 10 years – but this should have minimal impact on traders.
  • The product has an “issuer redemption” option which means that Barclays can use this provision to redeem the notes earlier if it becomes unprofitable to maintain the product.

Conclusion

Fundamentally, the VXX provides traders with an easy and efficient way to bet on extreme volatility in the markets.

The VXX is an Exchange Traded Note, meaning it can be bought and sold on an exchange just like shares, however, unlike an ETF, the holder of an ETN has no rights to the underlying security.

The VXX tracks the S&P500 VIX short-term futures index by buying the two futures contracts with the closest expiration dates.

Each day the portfolio mix is rebalanced such that movement in the VIX will result in changes to the price of the VXX (although on average, only 45% of the VIX move).

With a structure that guarantees long-term decline in value, coupled with periods of extreme price spikes that can wipe out investors, the VXX is often vilified by the mainstream media as a mere tool for gambling.

However, like any tool, it can be abused or used correctly – this starts with proper education and an understanding of how it works, including the risks involved.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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