The VIX doesn’t measure actual stock market volatility. Instead, it tracks trading in options on the S&P 500 to indicate how much investors expect the market to move over the next 30 days. As people expect bigger movements, options become more expensive, the VIX measures this level of expensiveness.
VXX is derived from the VIX, it’s a weighted moving average of 1st and 2nd month futures to create exactly a 1 month future average, it is meant to track a constant 30 day VIX future but its construction (by selling 1st month an buying 2nd month futures) has the side effect of being shrinked and amplified by contango and backwardation respectively. Backwardation is when far away futures are cheaper than closer ones and contango the opposite. backwardation amplifies the VXX because the VXX sells 1st month VIX futures to buy 2nd month ones, by doing this while in backwardation mode it can buy more 2nd month contracts with the proceeds of the 1st month sales increasing every day its total number of futures contracts components. For example if the 1st month VIX future =35 and the 2nd month VIX future =28 the proceeds of the sales of first month contracts can buy 25% more of 2nd month ones (35/28) that’s why the VXX can explode if backwardation or anti-decay persists, contango or decay has the opposite effect.
The VIX @35 means that traders believe the S&P could change from by 35% (up or down) over a 12-month period with a 68% probability, or about 10% (35/square(12)) over the next month.
XVV is not a vanilla derivative its a 5th degree derivation:
1st degree) XVV is derived from futures
2nd degree) futures are derived from the VIX
3rd degree) VIX is derived from options (out of the money)
4th degree) options are derived from a market index: S&P
5th degree) S&P is the average price of 500 companies
It can literally explode up or down in a matter of weeks specially explode on backwardation, contango decay is empirically “slower”
Learn how to calculate it if you plan to use it or do not complain if you are erased (for longs or shorts the same advice)
Look at this VIX graph
It is as of this writing date at 30, a year high, but it went up to 40 during the worse moments of last years European debt problems discussion and it went up to 80 during the 2008 crisis. But even then it only remained over 50 for a few weeks. It even has not been able to stay over 30 for more than a few months, and those months were during the great recession. Few times in history has it reached 40.
The thing in your favor is that the VXX etf is a product not designed to track the real VIX but its 1 month future price by holding 1st and 2nd month futures in a proportion such that they average exactly one month. So it holds near term futures and rolls a fraction of the 1st month ones every day before they expire to buy the 2nd month ones and have an average of 30 days futures, so they are strongly penalized by rolling the futures each time they sell the short maturities to buy longer dated ones, due to the fact that VIX futures generally are in contango mode which means that long term futures are higher than short term ones, so the VXX value decays because it can buy each time less future contracts by selling the short term ones. Basically they lose a percentage every time they roll their futures, that makes it seriously fall during contango times.
Now here is the problem if you want to short the VXX: during high and rising volatility you have backwardation instead of contango which is exactly the opposite effect, it’s the anti-decay, or meet the devil effect, it’s when short term futures are more expensive than long term ones, so they can sell short term futures for a lot of money and buy the next term ones cheaper, much cheaper if backwardation is strong, so they can get more future contracts while that lasts producing a multiplier effect that can push the VXX value up and wipe out a short. That can have a big magnifying effect on the VXX.
So even though above 45-50 it seems that shorting the VXX is a very long term safe bet be careful that on the short term it could go up enormously if volatility is rising constantly or only if it stays high with simoultaneous backwardation, then the VXX will increase. But one thing is sure, VIX always reverts to the mean and the ETF is biased to favour short sellers due to its serious underperformance when its in contango mode. Note that several ETFs that work this same way are biased to underperform the real index: USO for oil, and UNG for natural gas have the same problem.
I’m not saying you should run and short it today because the VIX increased, what I plan to do is to start doing it if it reaches over 40 or 45 and continue adding the way up. One thing is sure: volatility ALWAYS goes back to the mean people do not trade frenetically forever so its a safe long term bet if you do it at extreme high volatility times, but you can have huge temporary paper losses. I definitely will short that, hopefully soon I can start with some small positions.
If you invert the situation you might ask yourself why is this product successful, one answer is because short term speculators or black swan hedges could work. It could work if you have a magic ball or think that you can predict immediate panic (huge increases in volatility as measured by put options buying) and want to hedge yourself against it, like in the past few days. If you had bought the VXX a few weeks ago you would now be making a 75% profit but if you hold for too long that profit will for sure erode due to its nature of replicating the index by rolling of futures on the other hand it could go up to 500% in a recession like 2008/2009. So short term good speculators, if they really exist, could use it, but long term the etf is designed to benefit by taking short positions when the VIX is high… BUT be prepared for a wild ride and make sure you can stomach it financially and psychologically.
Here are historical examples of the effects of backwardation based on VXX data since end 2005:
05/07/2010 VXX=117 VIX=40.95
05/21/2010 VXX=133.24 VIX=40.1
Once backwardation creeped in between a fall back to the previous VIX did not make the VXX fall but increase!
Those are empirical facts.
Backwardation is just the opposite of contango: sell expensive 1st month VIX futures and buy a bigger quantity of cheaper 2nd month ones, it increases the contract base, if it lasts it’s devastating, another real example:
10/06/2008 VXX=223.87 VIX=52.05
12/11/2008 VXX=509.94 VIX=55.78
Only backwardation in between!
Even if the VIX goes up and down the VXX does not go back to its starting point on the same date as exemplified just above.
Not only that, in a stright VIX increase VXX increases faster:
09/18/2008 VXX 156.73 VIX 33.10
11/20/2008 VXX 590.87 VIX 80.86
VXX increased 379%
VIX increased 244%
Not a small bias. Then you might think as a short, no problem I shorted @156 when the VIX=33 it will go back there, yes it did but not VXX:
05/05/2009 VXX 352.18 VIX 33.36
As you see the VXX was still 8 months later more than 100% above your short EVEN given that the VIX recovered!
Here is a historical VXX graph since end 2005, as you can see both a long and a short could have been wiped out:
So do not forget that there is a possibility that it goes up five fold as it happened during the great recession so make sure you can withstand huge paper losses before making money with this, or make sure you short it at the right time. The data shows how you could be wiped out due to backwardation combined with long lasting rising volatility if you had shorted it before October 2008 or how you could have lost more than 90% if you had bought in 2009 thinking as a hedger that it would protect you from further market chaos.