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**Special Feature from the CBOE's Options Institute**

Russell Rhoads, CFA is an instructor with The Options Institute at the Chicago Board Options Exchange. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies and is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council.

1) VXX Is An Exchange-Traded Fund

The iPath® S&P 500 VIX Short-Term Futures ETN(VXX) is an exchange-traded note. Exchange-traded notes and exchange-traded funds both trade like stocks on a listed exchange. An exchange-traded fund is backed by securities or other financial assets that are held by the issuer of the fund. An exchange-traded note is actually a fixed income security that is created to track the performance of a certain strategy. A benefit of exchange-traded notes over exchange-traded funds is that there is no tracking error. The obligation of the issuer is to match the performance of a certain index. In the case of VXX the index is the S&P 500 VIX Short-Term Futures Index Total Return which is a strategy index that maintains positions in the front two-month CBOE Volatility Index(VIX) futures contracts. As of June 28, 2013 this index was 56.77% invested in July VIX Futures and 43.23% invested in August VIX Futures. Each day that weighting shifts a little away from July and into August.


It has already been established that VXX is an exchange-traded note with returns based on the S&P 500 VIX Short-Term Futures Index Total Return. VIX is the commonly known name and ticker for the CBOE Volatility Index. VIX is a measure of market expectations of near term volatility conveyed by S&P 500 Index Option prices. The performance of VIX is very difficult to replicate in a portfolio for a variety of reasons. Because of this there is not a financial derivative that perfectly replicates VIX. I am actually amazed at the frequency with which I see professionals commenting on the performance of VXX and referring to it as VIX.

3) Options On VXX Are Options On VIX

This misperception goes along with number two, however there is a little more to VIX with respect to options. There are index options on VIX with average daily volume in 2013 coming close to 600,000 contracts a day. There is also a very active market in options on VXX. Average volume is about 400,000 contracts for VXX and there are often days where VXX option trading is only second to SPY option trading in the exchange traded product space.

4) VXX Has No Relationship With VIX

VXX is not VIX, but VXX does have a relationship with VIX. VXX began trading on January 30, 2009 and admittedly is down dramatically (over 99%) since trading debuted. It is worth noting that VIX closed at 44.84 on the day that VXX began trading and is also much lower down over 60% from that level as of the end of the second quarter 2013. I ran a quick correlation analysis using Microsoft Excel and VIX and VXX daily percent price changes have a positive correlation of 0.8853. VXX has been trading for over 1100 days since debuting in 2009. The table below summarizes how often VIX and VXX move in the same direction on a trading day. Of those 1,100 or so trading days VIX has closed lower 608 times and VXX has been lower on the same day 541 of the time or just under 89% of days. Conversely VIX has risen 496 trading days and VXX also was higher 382 of those days or only 77% of those days. Those instances when VIX is higher and VXX loses value on the day are when VXX receives the most criticism. There is a lack of understanding regarding why VIX would go up and VXX move down on the day.

The reason for this sort of price action relates to the relationship between VIX futures and the index. More often than not VIX futures are priced at a premium to the index and the second month is priced at a premium to the front month. As futures approach expiration the value of the futures contracts will gravitate to the index. This price action can result in VIX futures losing value on days that VIX moves up. This price action would also result in VXX moving lower on the day despite VIX closing higher.

5) VXX Will Always Lose Value Because VIX Futures Pricing Is Always In Contango

For those unfamiliar with the term contango, with respect to VIX futures pricing versus VIX it refers to the pricing of futures moving progressively higher the farther the expiration date of the futures contracts. This has a negative impact on VXX as the strategy VXX was created to follow will consistently sell front-month futures and buy second-month futures. This buying and selling of futures contracts is done to maintain a 30-day weighting between the two. Often this means that cheaper futures are being sold and more expensive futures being purchased. Eventually the second month future becomes the front month and the strategy will sell those contracts and begin purchasing the farther month. Often when selling commences the price of the future is lower than when it was purchased and the vast majority of the time the front month is being sold for less premium than is being paid for second month.

The VIX futures pricing is more often in contango than backwardation. So far in 2013 the front part of the curve has been in backwardation only five trading days (out of 125 at second quarter end) and those instances have been very short lived. In 2012 the VIX curve was in contango every day until late December when the Fiscal Cliff situation resulted in a spike in volatility and VIX going to a premium relative to the futures contracts for a day or two. VXX does benefit from spikes in volatility and the VIX curve going into backwardation. The problem has been this sort of price action has been very rare for almost a couple of years. However, in 2008, before VXX was available for trading, VIX was in backwardation about 40% of trading days. Another period of time like that and VXX will benefit from the combination of higher VIX and backwardation.

VXX offers a good short-term trading vehicle to gain exposure to a potential spike in volatility. Despite having a persistent headwind due to VIX futures often being in contango, VXX will often rise when VIX is moving up and receive an added bonus to performance when the VIX curve is in backwardation. Over the long term VXX will experience some price deterioration, but in times of increased market volatility VXX is structured to give long holders the benefit of the increase in volatility.

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