How Does VXX Work?


Updated: Mar 10th, 2017 | Vance Harwood | @6_Figure_Invest

VXX and its sister fund VXZ were the first Exchange Traded Notes (ETNs) available for volatility trading in the USA.  To have a good understanding of what VXX is ( full name: Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN) you need to know how it trades, how its value is established, what it tracks, and how Barclays makes money running it.

How does VXX trade? 

  • For the most part VXX trades like a stock.  It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods.  With an average daily volume of 75 million shares its liquidity is excellent and the bid/ask spreads are a penny.
  •  It has a very active set of options available, with five weeks’ worth of Weeklys and close to the money strikes every 0.5 points.
  • Like a stock, VXX’s shares can be split or reverse split— 4:1 reverse-splits are the norm and can occur once VXX closes below $25.  For more on VXX reverse splits see this post.
  • VXX can be traded in most IRAs / Roth IRAs, although your broker will likely require you to electronically sign a waiver that documents the various risks with this security.   Shorting of any security is not allowed in an IRA.

How is VXX’s value established?

  • Unlike stocks, owning VXX does not give you a share of a corporation.  There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends.  Forget about doing fundamental style analysis on VXX.
  • The value of VXX is set by the market, but it’s closely tied to the current value of an index (S&P VIX Short-Term Futurestm) that manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts.  Every day the index specifies a new mix of VIX futures in that portfolio.  For more information on how the index itself works see this post or the VXX prospectus.
  • The index is maintained by the S&P Dow Jones Indices and the theoretical value of VXX if it were perfectly tracking the index is published every 15 seconds as the “intraday indicative” (IV) value.  Yahoo Finance publishes this quote using the ^VXX-IV ticker.
  • Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of VXX diverges too much from the IV value.  If VXX is trading enough below the index they start buying large blocks of VXX—which tends to drive the price up, and if it’s trading above they will short VXX.  The APs have an agreement with Barclays that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep VXX’s tracking in good shape.

What does VXX track?

  • Ideally VXX would track the CBOE’s VIX® index—the market’s de facto volatility indicator.  However since there are no investments available that directly track the VIX Barclays chose to track the next best choice: VIX futures.
  • Unfortunately using VIX futures introduces a host of problems. The worst is horrific value decay over time.  Most days both sets of VIX futures that VXX tracks drift lower relative to the VIX—dragging down VXX’s value at the average rate of 4% per month (30% per year).  This drag is called roll or contango loss.
  • Another problem is that the combination of VIX futures that VXX tracks does not follow the VIX index particularly well.  On average VXX moves only 55% as much as the VIX index.
  • Most people invest in VXX as a contrarian investment, expecting it to go up when the equities market goes down.  It does a respectable job with the VXX averaging percentage moves -2.94 times the S&P 500, but 16% of the time VXX has moved in the same direction as the S&P 500.  The distribution is shown below:
VXX% moves / SPX% moves

VXX% moves / SPX% moves (SPX daily moves of less than +/-0.1% are excluded)

 

  • With lethargic tracking to the VIX, erratic tracking with the S&P 500 and heavy price erosion over time, owning VXX is usually a poor investment. Unless your timing is especially good you will lose money.  For a backtest of VXX starting in 2004, see this post.

How does Barclays make money on VXX?

  • Barclays collects a daily investor fee on VXX’s assets—on an annualized basis it adds up to 0.89% per year.  With current assets at $1.15 billion this fee totals around $10 million per year.  That’s certainly enough to cover Barclays’ VXX costs and be profitable.  But even if it was all profit it would be a tiny 0.1% percent of Barclays’ overall net income— which was $10.5 billion in 2012.
  • From a public relations standpoint VXX is a disaster.  It’s frequently vilified by industry analysts and resides on multiple Worst ETF Ever lists.  You’d think Barclays would terminate a headache like this or let it fade away, but they haven’t done that even though 3 reverse splits—which suggests that Barclays is making more than $10 million a year with the fund.
  • Unlike an Exchange Trade Fund (ETF), VXX’s Exchange Traded Note structure does not require Barclays to specify what they are doing with the cash it receives for creating shares.  The note is carried as senior debt on Barclays’ balance sheet but they don’t pay out any interest on this debt.  Instead they promise to redeem shares that the APs return to them based on the value of VXX’s index—an index that’s headed for zero.
  • If Barclays wanted to fully hedge their liabilities they could hold VIX futures in the amounts specified by the index, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to accomplish that hedge.  If fact it seems likely Barclays might assume some risk and not fully hedge their VXX position. According to ETF.com’s  ETF Fund Flows tool, VXX’s net inflows have been $5.99 billion since inception in 2009—and it currently holds $1.15 billion.  So $4.8 billion dollars has been lost by investors and an equivalent amount by Barclays if they were hedged at 100%.   If they were hedged at say 90% they would have cleared a cool $480 million over the last 4 years in addition to their investor fees.  Barclay’s affection for VXX might be understandable after all.

VXX is a dangerous chimeric creature; it’s structured like a bond, trades like a stock, follows VIX futures and decays like an option.  Handle with care.

 

VXX-hist

VXX-hist-log

Purchase simulation of VXX 2004—2015

For more information:

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Friday, March 10th, 2017 | Vance Harwood
  • Anders

    Hi Vance,

    I don’t understand your above comment. The number of outstanding VXX notes is 100% percent controlled by Barclay’s since they are the only ones who can issue new bonds. Investor outflow cannot decrease the number of outstanding notes since you have to sell your notes to another investor. The 5% price drop per month decreases the total outstanding debt obligation Barlcay’s has to the VXX holders but does not affect the number of outstanding notes. The best way to think about the VXX is like a corporate bond whos value is index linked to to the short term VIX futures index.

  • Anders

    Hi again,
    I missed that you can redeem early so your are right Vance, sorry. If you look at my other recent post you will see that it is hard to redeem for a private investor. Also if you look at the net assets of the VXX at yahoo finance you can see that it is 1.13B and if you calculate the current value of all the notes Barclay’s has issued I get a value of 1.1B so it seems redemptions have been very rare or non-existent. If you want I can email you my spread sheet which has collected the information of all VXX issues.

  • Hi Anders,
    I think it is important to distinguish between shares and the overall bonds/notes. Shares are easily redeemed/created by the authorized participants in interacting with Barclays, this happens all the time as the assets under management grow and shrink in the range of 100s of millions of dollars. Since inception more than $5 billion dollars of creation dollars for shares have flowed to Barclays. That’s not to say that all of that was profit for Barclays–they are certainly hedging their position, although maybe not at a 100% level.

    — Vance

  • anders.vilhelmsson

    Hi Vance,

    But in the case of an ETN as opposed to an ETF do any shares actually exist? Are you not trading the issued notes directly? To my understanding an ETN is not a fund and it does not hold the assets the note’s value is tied to. Isn’t what you call “the assets under management” simply the value of the 70M issued notes? This value will vary by hundreds of millions because of price changes in the VXX.

    Split adjusted, Barclay’s has as of March 18, 2015 (I could not find any issue after that) issued 70M notes. The NAV yesterday (April 28th) was 16.22USD which gives a value of 1.135B USD which corresponds very closely to the 1.13B listed by Yahoo finance.

    Barclays has issued new notes on 27 occasions since inception and raised 10.6B in capital which gives a profit of about 9.5B if unhedged. I have put all the issue dates, size of the issues and the VXX value at the issue dates in a spreadsheet if you are interested.

  • wwt17

    I rarely ever go long VXX and never during times of serious contango like we are experiencing presently. Also, you don’t know if that open interest represents longs or shorts. I would be willing to be the open interest is ppl looking to sell calls. Short VXX on VIX spikes and then sit tight, short more when your position gets too small, and watch the proverbial paint dry. Isn’t VXX slated to be shuttered in 2019?

  • Hi wwt17,
    VXX’s notes are scheduled to mature in 2019. Since it is a money maker for Barclays they will figure out a way to extend it, either by amending it, or opening up a new set of notes.

    — Vance

  • wwt17

    It’d be nice not to have a big tax hit on VXX in 2019! Not really germane to the discussion, but I think shorts should be treated the same as longs as far as L/T, S/T cap. gains are concerned.

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  • Jack Bocanegra

    Hi Vance-
    What about “XIV” (reverse VXX) ………..is that effective or ineffective at moving up when the VIX declines ?

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  • Scott Gifford

    I wish I have seen this article before I took my position at the pre-split price.
    Currently own 40 VXX 1/2018 Strike 60. Now they are called VXX1 (ask .40 Bid 0)
    I can’t even sell them. My lost is $3,000
    what an expensive lesson it was. Barclys your a scam business.

  • Hi Scott, At the risk of offending you, do you know that you can put in a limit order between the bid/ask price? The current bid/offer is 0/.45. My rule of thumb is that normally you can usually get a limit sell order fill at midprice between the bid ask, or a nickel less in the market makers’s favor. In this case I would start with .25, let it sit for 10 minutes, drop it to .20, sit for 10 minutes, drop to .15, Normally I would be surprised if it didn’t fill at at least .15, but it could be that these adjusted strike series are just horribly liquid. I would be surprised if you couldn’t get some sort of fill above zero.

  • Scott Gifford

    Hi Vance, no offense taken. I am thinking to hold on in case of a major event that might spike the vxx much higher. I don’t know I am just at a lost on best course of action.

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  • Skeptigal

    Yeah, me too. so what? Just hold it or sell? Could it really go to zero?

  • Giulio

    Thanks for this and many others interesting posts! Only a question, I see that on investing.com the name is “iPath S&P 500 VIX Short-Term Futures Exp 30 Jan 2019 (VXX)”… The expiration date “30 Jan 2019” what does it mean? Thanks in advance!

  • Hi Giulio, I called Barclays regarding this. The person I talked to said that they can’t just extend the date on VXX, so they will very likely create another ETN like VXX that has a farther out expiration date. I suspect they will figure out how to move the VXX ticker over to this new fund, but that might be an open issue.

    Vance

  • Joe Herzig

    How does this instrument still exist except for traders? Seems to me that shorting this thing over the long term is money in the bank. Granted it could explode against you very quickly, but even taking a ’08 type vix spike into account (such a scenario would send VXX to $150 from a $38 level today or x4 in a few days) but If you can muster the margin requirement (cash) to cover the short position loss, you could make 50% a year? Certainly not for the faint of heart. I’ve always heard shorting vol is like picking pennies up in front of a bulldozer, but wouldn’t mind hearing your thoughts.

  • wwt17

    I’m a bit late to the conversation, Scott, but I would say holding and hoping for a gigantic spike is just smoking the hopium. Even if there were a spike like 2008, you would never get back to your cost basis. You learned a lesson, an expensive one. We’ve all been there. Your best way to play VXX is to just short a small position and hold until the instrument is closed down, periodically adding when the size becomes irrelevant in your portfolio.

  • Scott Gifford

    Never held it and sold the options the night of Trump winning. Cut my losses 30% and never looked back.
    VXX is a day trader if that.

  • Scott Gifford

    Carlos thank you for your concern. Your such a professional.
    What advice do you suggest for us to buy to recoup our losses?

  • wwt17

    I beg to differ. It’s a GREAT short to hold. I trade a lot of options around my core position, but I’ve had a direct short since 2013 and have added to it after reverse splits. VXX will always trend down for all the reasons stated in the above article. I consider spikes in VIX a gift from the market gods. Those are the times to add to the core position, write calls and/or ad a short term portion to the short. Sell and Hold VXX for sure.

  • wwt17

    Carlos needs to learn about decorum, but he’s right in that you need to acquaint yourself with anything before you consider adding it to your port. As I posted above, you might just consider a short position in VXX. Just be careful with your sizing. I keep VXX about 1%.

  • Ron Miller

    Maybe a little harsh, right?

  • Pengkui

    An open interest is just an open option contract that is not closed yet: I write an option and you buy it from me – this constitutes an open interest.

  • M.

    hi Vance,

    Is this ETN considered an IPU (index participation unit) and can a mutual fund invest in it?

  • Hi M, I don’t think VXX is an IPU. It follows an index, but it’s not a passive trust, the issuers are actively creating / redeeming shares. I don’t see any reason why a mutual fund couldn’t invest in VXX, it’s an active, listed security.

  • M.

    hi Vance, a mutual fund can only invest in an ETF if it’s considered an IPU. If it follows a widely quoted market index in the US or Canada then it’s considered an IPU. But i dont think the index it follows is considered a widely quoted market index. i tend to agree with your explanation though it doesn’t follow the index passively, but by way of derivatives? does it use leverage?

  • Hi M, VXX follows SPVXSTR which seems to me to be is a widely quoted index, As described in the article VXX’s market value is kept close to the index value via the arbitrage actions of the authorized participants.

  • John

    One thing I don’t understand is this. The “Authorized Participants” intervene in the market to make sure VXX stays reasonably close with ^VXX-IV. For VXX, most of the traders are short-selling, which means the APs are buying and end up with a huge unrealized loss.

    Is anything going to happen to their long position? It doesn’t look like APs or Barclays are going under because of this, but in which case who’s losing the money as shorts make money?

  • The authorized participant (AP) involvement is very low risk for them. In the case you mention, where there is a lot of shorting, then the trading price will tend to drift lower than the IV price. In that case the APs will buy the underpriced VXX shares and hedge their position at the time by shorting the appropriate VIX futures positions. This locks in their profit. They close out their positions end of day by presenting the VXX shares they have for redemption. The ETN issuer (Barclays in this case) gives them cash in exchange for the VXX shares at the end of day IV price. The APs close out their VIX futures positions at the same time, so the transaction is netted out with a profit.

    If VXX is trading higher than the IV then the APs short VXX and take long positions in VIX futures to hedge their positions.

    For Exchange Traded Funds (e.g, VIXY) , the issuers internally hold the actual shares of the underlying index (VIX futures in this case) so when the shares are redeemed they deliver the actual futures instead of cash. The APs use those directly to close out their VIX futures short positions.

  • John

    Vance,

    Thank you very much for your quick yet elaborate response! Makes a lot of sense now.

  • ALP

    Vance,

    How does buying and selling VXX affect the price of VXX, – a little, a lot, or not at all?

    Since VXX is calculated from the two nearest month’s VIX futures contracts, that might mean that buying and selling VXX has no effect on the price of VXX – only trading in the VIX futures.

    Since VXX is an ETN, I would expect that buying and selling VXX might result in buying and selling these two VIX futures contracts involved in calculating the price of VXX.

    But your article “How Does VXX Work?” says:

    “If Barclays wanted to fully hedge their liabilities they could hold VIX futures in the amounts specified by the index, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to accomplish that hedge.”

    That implies that my buying or selling VXX does not necessarily cause Barclay’s to buy/sell the VIX futures on which the price of VXX is based.

    So, when the price of VXX starts running up, that is not necessarily because there are a lot of people buying VXX. It can be due to reasons that have nothing to do with the trading demand for VXX. Right? What are those reasons?

    Can you enlighten me?

    Thanks,

    Alp

  • ALP

    Vance,

    Sorry for all the words. It would have been clearer to ask:

    If no one is buying or selling the VIX futures, but a lot of people start buying VXX, would the price of VXX go up?

    If so, would that be because of the demand for VXX, or another reason?

  • John

    VXX won’t go up because Authorized Participants start shorting VXX in that scenario. Think of this like the SPY ticker that tracks S&P 500. The buy demands cannot derail SPY from tracking S&P 500 and vice versa.

  • Hi ALP, There are two issues here, one is how well does VXX track the front month VIX futures and the other is a liquidity issue–if someone bought billions of dollars of VXX what would happen.

    Regarding tracking–as commented by John in his comment in a normally functioning market the APs keep the price of VIX futures / VXX closely linked. If the calculated values differ by much, a percent or two then they do coordinated buy/selling operations that lock in risk free profits.

    At some point extra-ordinary amounts of VXX buying would influence the VIX futures market too. If the buying pressure on VXX was heavy, the APs would be shorting VXX as it diverged from it’s IV price calculated by the underlying VIX futures and buying VIX futures to hedge their shorts. The VIX future market is like any market, if there is an unusual amount of buying it will tend to drive its prices up. WIth heavy demand VIX market makers would be raising their prices and hedging their positions with VIX futures of other months, VIX options, and SPX options–which would impact their prices. If there was nothing else going on other than this extra-ordinary amount of VXX buying this constellation of hedging choices associated with VIX futures would blunt the impact of the buying on the VIX futures prices. The wagging tail might move a the dog a bit, but not much.

  • John

    I’d be curious to learn what happens when everyone shorts VXX. APs would buy VXX shares then sell VIX futures; will Contango eventually go away as a result? Shorting VIX ETFs is getting widespread attention these days and people are making money, and I find it hard to believe that there is no downside to this trading strategy.

  • Hi John, Despite all the press if you look at the actual ETP assets under management they are relatively balanced between the short and long funds.

    Heavy shorting of shorter term futures tends to increase contango because the associated selling depresses their prices.

    The downside is simple–volatility spikes can do huge damage to short volatility positions. People are routinely blown out of their positions if they aren’t equipped emotionally / with enough margin to survive volatility spikes.

  • John

    “Heavy shorting of shorter term futures tends to increase contango because the associated selling depresses their prices.”

    That’s actually making this trade even sweeter then 🙂

    On volatility spikes – I’ve analyzed past VXX data and iirc the biggest overnight gap-up was around 10% (I’m on a business trip so I don’t have the data, but easily verifiable via yahoo finance). While 10% isn’t small, it’s not that big either. And intraday run-ups can easily be mitigated by stop-loss orders. Tbh I don’t find volatility spikes that concerning, personally.

    If one keeps on shorting volatility during financial meltdown like 2009…well, they have themselves to blame. But we all have plenty of time to get out before that.

  • John

    Just a silly question, do Authorized Participants intervene during pre-market and after-hours when pricing deviates from the indicative value? My trading style would be placing market orders overnight, so if they aren’t intervening pre-market then my pricing can get jacked up whenever I trade.