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
  • Hendra

    this article is really great!!
    thanks a lot Vance

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  • Andrew_notPorC

    This makes me wonder why CS got cold feet with TVIX. Really, issuing long VIX index ETNs is a bit of a gold mine.

  • Hi Andrew, I’ve been wondering the same thing. I suspect they panicked because the short term capital requirements were kicking up into the hundreds of millions and they were getting hit with expensive swaps, etc. If they were trying to hedge near 100% it could be ugly. On the other hand as you say, it’s a long term gold mine–if they’re willing to take some short term risk.

    — Vance

  • Doferson

    I have been writing call spreads on this piece of crap since march…They keep expiring worthless, I keep collecting premium. What a gold mine!

  • Doferson

    …is it time for a 10 to 1 split?

  • Probably won’t be until February– and will be a 4 to 1 split. http://sixfigureinvesting.com/2013/08/next-vxx-reverse-split/

    — Vance

  • Marco

    Hi Vance,

    thanks for educating ‘the world’ about VXX and the like.

    I have one question:
    At what time of the day does the index that VXX tracks roll its future position (or does that even matter)? Is the roll executed ‘on the close’ (and when is that for VIX futures?) If it is on the close how do Barclays and other people who follow that index execute their hedge? I doubt they all do their roll at one time of the day.
    How does that work?

    thank you.

  • Hi Marco, The index that VXX tracks uses the closing (settlement) values of the VIX Futures for its computation. The close is at 4:15 ET. Yes it is a catch-22 situation. I don’t know the specifics of what goes on, but my understanding is that most of the day’s volume does occur at close. It appears that the exchange is accommodating the needs of the hedger by often extending trading quite a bit beyond 4:15. In September the CBOE plans to start VIX Futures trading for the next business day around 45 minutes after the normal close. This would allow hedgers to adjust their positions without taking overnight risk.

    — Vance

  • Marco

    thanks for your comments Vance

  • windwine

    Hi Vance,

    Based on the ETN nature of VXX I think Barclay might not be fully hedged and that might make Barclays an LTCM ver 2 in an adverse event. In my understanding, the ETN does not require physical holding of the corresponding futures or whatever replication portfolio. When Barclays issue one share of VXX at today’s price, simply it is collecting the 14.48$ as of 09/11/2013 and promises the buyer whenever you want to redeem/sell the share it is available. Under such scenario, Barclays essentially is shorting VXX or more broadly speaking shorting volatility. It is willing to do so because VXX is decaying like no return and generally it is very profitable to short volatility. If Barclay is not hedged at all it is collecting both the fees and the short profits (4.8$ Billion as you mentioned) in VXX.

    However, this seemingly sweet deal could also blow Barclays up. If anadverse market event happens and VXX triples or quadruples in just a few days, Barclays might lose its profit for a whole year since during that turbulent period it might not be able to hedge its positions and its hedging action could only aggravate the crisis. With a Net asset of 1.15$billion and growing Barcalys could easily lose several billion dollars if most of the VXX holders are redeeming their shares.

    That is just my wild guess and I hope nothing that catastrophic would happen. Not for the bankers, but for the ordinary working people. Any financial crisis could only make our life more miserable.

  • I agree that Barclays is probably not fully hedged, but I doubt their risk management controls would allow them to go completely unhedged. Historically the open interest on VIX futures does not drop all that much during market panics, even though the longs had huge profits–we do have 2007/2008 data on VIX futures. I think it relates to the tendency for people to want to jump on the band wagon–the momentum traders. That will tend to offset the people that are taking profits and exiting.

    At this point I believe the VIX futures market could soak up a lot of demand without significantly distorting prices. Any significant price distortion creates arbitrage opportunities between VIX futures and SPX options. The SPX options market is incredibly deep with tens of billions of notional value in single strikes of single expirations dates. The VIX futures market is still way to small to move that market around.

    — Vance

  • Nick

    Nice article Vance! I’m just wondering where you got the VXX data for the 2004 to Jan 2009 period. I’m assuming you generated these theoretical values based on what the first and second forward futures contract prices were? Do you know where I could get my hands on that data? I would sure appreciate being able to save the time and headache of constructing the time series myself!

  • Nick

    What I meant is where I could get my hands on the theoretical VXX time series, of course — not the futures data.

  • Hi Nick, I offer a spreadsheet that provides the theoretical VXX values (including fees) back to March 2004 for $30. As you suggested I generated it from the CBOE’s VIX Futures data–not a trivial task. If you’re interested send an email to [email protected].

    — Vance

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  • JhM

    I just came across this because it was exactly what I was thinking. This seems to be the ideal spread situation. I can’t be that easy. Even though If you look at the ATM put and call the prob of expiring out of the money indicates the tendency of contango but the prices don’t! Am I missing something here? I know I have to be, it’s never this easy.

  • JhM

    Vance, what am I missing here? The call prices don’t seem to indicate contango as the chart does. Why wouldn’t everyone just sell call spreads into perpetuity?

  • Hi JhM, It’s never easy in the long run. Being short volatility works great until a correction rips your ears off. Volatility can spike very quickly. I’m not sure what price disparity you are seeing. Put / Call parity will keep things roughly aligned even when the risk is asymmetric.

    — Vance

  • The risk is volatility spikes. If you get greedy you can lose a lot of money in a hurry.
    — Vance

  • JhM

    I actually found my answer. The calls trade richer so you’re going to risk more on the spread…still I’m not sure I get this underlying. It basically looks like a sure thing.

  • JhM

    Thanks for the quick response. I think I figured out the problem. Calls are really rich. I’m trying a skewed iron condor to the downside. I would normally make it a broken wing butterfly but the capital requirements go up 4x if you don’t cover the put side. Have you ever thought about a trade like this?

  • The premium available on the put side seems really thin–doesn’t seem worth the risk. Why not just call credit spreads?

  • JhM

    Well I don’t really see any real risk to the down side. I skewed it taking into account that 5% a month loss to contango selling the 27 call and the 26 put 30 days out. That should work. This is a unique underlying. Are there any others that you know of that behave similarly and also have liquid options?

  • I suspect you’ll see your puts go ITM. VIX Futures have been riding a bit high in my opinion. Other vol ETP’s with options/decent liquidity: UVXY, SVXY.

  • michael

    I will ask a stupid question, sorry about that, but why would anybody buy VXX over VIX ? I feel that VIX is much more appropriate for the kind of security people are looking for, as it follows properly SNP500 ? Thanks for the article !

  • Hi Michael, It turns out that’s not possible to directly buy the VIX. People talk like they do, but in reality they are buying a volatility future or exchange traded product–neither of which track the VIX very well. For more see: http://sixfigureinvesting.com/2010/01/how-to-go-long-on-the-vix-index-2

    — Vance

  • michael

    Thank you very much ! I just bought some TVIX earlier today, do you expect any tendency from it ?
    Your website is great by the way, thank you for dedicating this time to inform people, it’s really appriciated.

  • Regarding TVIX, just remember once volatility peaks and starts to decline TVIX’s value will drop very rapidly.

  • supresistance

    Why wouldn’t a person just short this on the spikes and hold? Doesn’t it decay no matter what over time?

  • Balliquicknatiasiah.

    Vance,

    Quick question you mentioned in the article bid ask spreads were slim, today it is like almost $2.45 dollars between bid and ask . I am wondering if this is normal or is it just because I am looking at it after a volatile day.

    Source was Yahoo currently bid is 41.10 x300 ask is 43.55x 500 and the current price is 39.41. Just wondering if this is natural.

  • Hii, Those are after-market ask/bid prices. Check during regular market hours and you’ll see the penny spreads.

    — Vance

  • Shorting VXX is popular. However shorting the right spike can be tricky–volatility often has a triple spike before a correction is over. If youi’re too soon you better have deep pockets ’cause the margin calls will be a coming. Also, a short can at best give a 100% profit, see http://sixfigureinvesting.com/2014/03/short-selling-securities-selling-short/ If you hold your position for a long time a daily reset fund like XIV or SVXY will perform better.

    — Vance

  • Balliquicknatiasiah

    Thanks Vance I checked on the spreads this morning and penny to the red cent! I appreciate your help and great article.

  • thomas

    Hi Vance, if S&P reverses from here and drop back to 1800 in a month, wouldn’t VXX follows suit, meaning spike up? will it be a quick spike? I see that index like dow are moving 3 digits almost every other day…

  • David

    Hi Vance,

    What do you think about short the VXX using options ( long puts ATM + short calls ATM ) instead to short directly the ETN?

    David.

  • Hi David, The synthetic short long put / short call combination) will work. Right now it looks like you pay around a $1 premium for the ATM options, but that would probably be fairly stable until close to expiration. In VXX’s case no real worries about call option assignment because it has no dividends–and therefore no ex-dividend dates to worry about.

    — Vance

  • David

    Thanks Vance.

    And I have another doubt. Is it possible to know how many new shares of VXX are “created” every year by Barclays? Do you thing that knowing it we could have an idea about which are Barclays future expected lost value of this ETN?

    Thanks in advance,

    David.

  • Hi David,
    The number of VXX shares created / destroyed in a year is not knowable by anyone because it depends on investor inflows / outflows. Barclays does not control that. Normally VXX decays around 5% a month but that is dependent on the general state of the market (e.g, bear or bull) and the amount of contango in the VIX futures.

    — Vance

  • David

    Ok Vance,

    But how it’s explained the difference in performance between VXX and XIV? If I supose the same investing amount every day ( long XIV vs. short VXX ), the profit obtained shorting the VXX is much more that can be explained for the ETN fee ( 0,89%/year ).
    I understand that the two ways to trade have to be inversely similar, but in reality if you choose to short the VXX the profit substantially more than buying the XIV, even taking account for the expenses to borrow the shares.

    What’s the reason? What is the effect that I’m not taking account and provoque that disparity?

    Could you figure it?

    Thanks, again, in advance. Your site is simply fantastic but it remains small compared with your kindness to help.

    Regards,

    David.

  • Hi David,

    The mechanisms at play here are related to the compounding that is inherent to the operation of the daily resetting leveraged funds (-1X and 2x) . The compounding tends to erode the value of leveraged funds if the volatility of the underlying securities is high, and boosts them if the underlying security goes into a strong supporting trend.

    I discuss the underlying operation in this post, http://sixfigureinvesting.com/2012/03/under-the-hood-of-a-leveraged-etf/ and I give some additional examples in http://sixfigureinvesting.com/2012/10/a-hat-trick-for-inverse-leveraged-volatility-funds/

    The fairly frequent trips the vix has made into the 20’s recently has propped up the value of VXX and the general increase in the realized volatility of volatility has eroded XIV and SVXY.

    Best Regards,
    Vance

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  • Chris

    Would it not make sense for a long term investor to buy VXX while it’s so low, assuming that eventually volatility will increase? And after XIV hits near 52 week lows, sell VXX and buy XIV? Seems pretty straight forward. What am I missing?

  • Hi Chris, Being long VXX is only a short term strategy. VXX decays much like an option, so even though volatility will eventually increase from its current levels your losses due to the decay process will likely consume any profits you might get. Normal VXX losses are about 5% per MONTH.

    — Vance

  • Anders

    The VXX tracks futures prices. If volatility is anticipated to rise in the future, then this will already be reflected in the VIX futures and hence in the VXX. More technically speaking futures prices are semi martingales.

  • Iyad Abbas

    I want to write a call credit spread against VXX but my hesitation is that a reverse split is coming soon. Any idea what would happen if I had spread open?

  • Hi Iyad, First of all I think the reverse split will still be a while, historically VXX is trading around $13 when it happens. Nothing horrible happens to options when there’s a split. On a reverse split the strikes are reduced (4X in this case), so that the net value stays the same. Liquidity of the adjusted strikes might not be that good so it might make sense to exit before the split happens–there is advance notice of when they will happen. See http://sixfigureinvesting.com/2014/01/uvxy-reverse-split/ for more discussion on options and reverse splits.

    — Vance

  • matt

    Hi Vance, on the VXX May 16 Calls – 20 Strike price, there is over 50,957 in open interest. Does that indicate anything? I am long with 20 contracts at that strike price. Not sure if I should get out or wait to see if there is small pop up on the VXX.

  • Hi Matt, I don’t think open interest is predictive, just means a lot of activity at that strike. Signals on market are quite mixed right now. VIX is low, historic volatility is low, VIX/VXV ratio is low, but RSI is high, VIX futures are at a premium. Your ~$500 position is essentially a bet on a big vol spike in the next couple of weeks. Feels to me like maybe a 20% chance it will pan out.

    — Vance