The VXX is the largest and most liquid volatility ETN (electronically traded note) in the world. There is always a misconception that VXX and VIX are one and the same, but while they have a relationship, they are conceptually very different.
The VXX is a ticker for the CBOE Volatility Index and is basically a measure of the market’s expectation of near-term volatility of the prices of S&P 500 stock index options. On the other hand, the VXX, a ticker for the iPath S&P 500 VIX Short Term Futures, is essentially a debt instrument designed to track the performance of a defined strategy, in this case, the total return of the S&P 500 VIX Short-Term Futures Index.
VXX only began trading on January 30, 2009 and essentially allows investors to speculate on the VIX, and thus the degree of volatility in the US equities market. Generally, when volatility is expected to rise, investors will buy the VXX; and they will short the VXX when the expectation is that volatility will decline.
Like price and volume, volatility has been known to move the markets tremendously and, consequently, has a great impact on investor portfolios. Whether volatility is high or low, the VXX offers investors a unique opportunity to mitigate risk over time, as well as a chance to book massive trading profits.
How to Calculate the VXX?
VXX is composed of a certain number of first-month and second-month VIX futures, and its value models the returns one would derive from holding the contracts throughout the periods, between expiration dates.
The arbitrary formula of calculating the price of VXX is as follows:
VXX = (p1*n1+p2*n2)/c
Where p1 and p2 represent the prices of the first and second-month VIX futures, and n1 and n2 denote the number of first and second-month futures contracts. N1 and n2 are chosen so as to have a 1-month average future lifetime of the VXX. C is the contract base.
This formula makes the VXX very vulnerable to both contango and backwardation, as these two factors significantly impact the contract base. Contango (or upward sloping) is when the futures price is higher than the expected future spot prices, while backwardation is when the futures price is lower than the expected future spot price.
Because a futures price eventually converges to the expected future spot price, contango is less desirable for speculators, whereas backwardation is more appealing. The VXX is rebalanced daily, which can lead to price erosion. This, as well as the mentioned mean-reverting tendency, makes trading the VXX on the options or futures market inherently risky.
How to Efficiently Trade the VXX?
As a Volatility ETN, the VXX is inherently risky to trade. Its composition also makes it difficult to trade in traditional markets. While it trades like a stock, it follows VIX futures and its structure is bond-like. It also decays, like trading options. Still, the VXX offers exposure to overall market ‘fear’ and ‘greed’, without the unnecessary burden of predicting market direction.
It has, however, shown a negative correlation to the S&P 500, usually rising when equities decline and vice versa. Historically, it has also proven to overshoot the moves in the equities market. This means that if, for instance, stock trading make a 5% upward move, the VXX can be expected to overshoot this move and post even a 25% downward move. With this information, VXX traders can ride volatile times in the market profitably.
The VXX and S&P 500 are not perfectly negatively correlated. This naturally gives traders opportunities to effectively time market reversals with minimal risk. For instance, a rising VXX and a rising S&P 500 would imply a bearish divergence with more likelihood of falling equity prices. Similarly, a falling VXX and a falling S&P 500 would denote a bullish divergence with more likelihood of rising equity prices.
The nature of VXX makes it a great hedge for equity positions, but its price overshoots also open up money-spinning opportunities for short-term traders who are chasing the profit motive. Additionally, trading the VXX as a CFD further reduces market exposure and dramatically enhances the profit potential due to availability of leveraged trading.