Cherry Picks: Why VXX Underperforms the VIX Contango and the Futures Roll
Cherry Picks: Why VXX Underperforms the VIX Contango and the Futures Roll
By:Tom Preston
Even experienced traders can have trouble understanding, much less trade, the VIX products. After all, the VIX is derived from SPX options, and you can’t even trade it. /VX futures are tradeable, but have a tenuous relationship to the VIX itself. And /VX futures options can look funky because they’re not priced off the VIX, but the /VX futures. Add in the VXX, the ETF that’s supposed to track the VIX by holding a portfolio of /VX futures, and I’ll admit it can get a bit confusing. But let’s clear up a big question about the VXX.
A problem the VXX has is its seemingly unstoppable downward price path. While the VIX itself might be steady, the VXX moves lower.
So, why the drag?
Because the VXX holds a portfolio of front and next month /VX futures, and those futures expire, it has to roll the futures from the positions in the front month to the next month to always maintain a portfolio. And it does so systematically.
Every day, the VXX rolls about 4.5% of its front month /VX to the next month /VX. So, when a /VX future becomes the new front month (after the previous future expired), the VXX has 100% of its portfolio in that front month future (e.g. March) and 0% in the next month future (e.g. April). The next day, VXX sells 4.5% of its front month March future and buys 4.5% of the next month April future. It repeats this every day until the expiration of the front month March future is expiring, at which point it has 100% of the next month April future.
When the /VX futures are in contango, where the next month future has a higher price than the front month future, the VXX is selling a lower price /VX future and buying a higher price /VX future. Because the /VX futures are in contango most of the time, the cost of the roll is the drag we see in VXX. But when the /VX futures are in backwardation, where the front month future has a lower price than the next month future, that can benefit the VIX.
So, the question is, is there an advantage to buy the VXX when the /VX futures are in backwardation?
Over the past 17 months, the one-month /VX basis has gone into backwardation 9 times. But in the days after, while the VIX has rallied an average of 26.4% vs 11.2% for the VXX.
These backwardation events happened when market sold off and VIX went up. These numbers illustrate the phenomenon of the VIX moving up the most, and futures moving up less the further out they are.
Roughly 70% of the time, the VIX trades in a range, 10% of the time goes up, and 20% of the time it goes down. When it’s low, say, under 15, and market complacency is high, the possibility of a big statistically large sell off in the S&P 500 is higher. But it’s likely that the big move down might take months or more to happen. So, the drag makes it harder to hold a long position in the VXX to bet on a rally. And when the VIX does go up, the VXX typically doesn’t go up as much as the front month future.
That’s why if you are bullish on the VIX, short put verticals or long call verticals in the options of the front month future could be a better choice than in the VXX.
Tom Preston, tastylive chief market strategist, is responsible for the brokerage’s trading strategy, client-facing trading software and futures trading products. He writes tastylive's Cherry Bomb newsletter. He's been trading options since 1992. For live daily programming, market news and commentary, visit tastylive or the tastylive YouTube channel. Trade with a better broker, open a tastytrade account today. tastylive Inc. and tastytrade Inc. are separate but affiliated companies.Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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