VXX: Negative Roll Yield

What are the odds that you'll be struck by lightning tomorrow? Pretty low. What about the odds of being struck by lightning any time between today and ten years from now? Still low, but slightly higher. Implied volatility increases with time, too: the more time there is until an options contract expires, the more chance there is for the underlying asset to move in a wider range. That's why options on the same asset with the same strike price - differing only in their time until expiration - will typically trade at different levels of implied volatility.

CBOE Volatility Index (VIX) tracks the value of two strips of SPX options with an average time to expiration of 30 days, and VIX futures contracts track the expected value of the VIX index at various future dates. Because more can happen in six or seven months in the market than can happen in one month, the value of longer-dated VIX futures is, under normal circumstances, higher than the value of short-term contracts. The shape of this term structure, contango, means that each futures contract will decline in value as time passes, even if the underlying (the spot VIX) does not change in value and the market does not become more or less volatile.



As I explain in the embedded video, the negative roll yield in products like iPath S&P 500 VIX Short-Term Futures ETN (VXX) is simply a function of the passage of time and the shape of the VIX term structure. Because VXX is designed to maintain a constant 30-day horizon, it constantly buys and sells a series of first- and second-month VIX futures contracts. In early March, VXX will track the value of March and April VIX futures, with more weight put on April. By late March, the index will track an even mix of April and May contracts. If all else is equal (the market does not move and SPX implied volatility does not change), we would still expect the value of the April VIX contracts to be lower one month from now than they are today. The April contracts "purchased" by VXX today will probably be sold at a lower value a month from now in order to gain exposure to higher-priced May contracts. If the difference between the first- and second-month contracts is small, the roll yield will be small. But when the term structure is steep, as VXX gradually changes its exposure each day to maintain a constant time horizon, the ETN will incur larger costs.

VXX isn't broken, despite what you may have heard on Twitter or on the message boards. It functions exactly as intended, and if you try to maintain long volatility exposure using VIX futures, or using at the money SPX straddles, etc., you will incur the same sorts of costs. Understanding what drives VXX changes will allow you to spot opportunities for profitable trading and cost-effective hedging, like selling volatility during normal markets and buying VXX when the term structure inverts.

On Saturday, March 24, the CBOE, Option Pit and OptionsProfits are hosting a full-day course, The Professional Approach to Trading SPX. CLICK HERE FOR INVITE AND TO REGISTER.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.

Jared can be followed on Twitter at twitter.com/CondorOptions.
At the time of publication, Jared Woodard held positions in VXX, VIX, and SPY.

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