Watching the VIX index for a possible short

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.


About jrv

I was born in Spain and lived in Belgium, Chile, France, USA, Argentina among other places. Currently I am trying to settle down in a wild place. I am "retired", even though now I dedicate more hours "working" for my investments than I ever worked in the real labor market where I used to work in IT and Banking. I am a family man, I have a lovely wife, several sons and one step daughter. I have humble tastes, I like to stay home and read about companies and investments. I started investing at 25 before the internet bubble exploded. I did not know much about investing and liked technical analysis so my results were pretty bad. Fortunately I did not have much to lose. Some years later in 2006 bored of doing only real state investments and with quite a lot of money saved I opened an account in a cheap and excellent online broker and started again. This time I did not want to commit the same mistake, so I decided to follow a model. I heard that Warren Buffett was the best at making money via stocks so I started by reading a lot about him, all of his shareholders letters and several of the books that he recommended. I learned a lot, started applying his investing principles and reading a lot of 10K's. Digested news from lots of different sources. Basically I started buying very good and cheap companies and holding them for ever if possible and if nothing changed fundamentally. When the housing crisis started I was more than 75% cash. At that time I identified good companies at incredibly cheap prices so I invested most of my savings in stocks. In less than I year I doubled. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. My wife and I decided to change our lifestyle and moved from Belgium to the beach in a wild country. The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return but specially to move away from the inhuman life of civilization and to have finally some peace and sunny weather to concentrate better on investing. Now I can think and study about companies 60 hours a week and I am doing great. I can finally do what I want full time and can proudly say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! You can learn a bit more about my portfolio by viewing it at or you may learn more about me and my family by following the link "Author's site" from the menu above.
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5 Responses to Watching the VIX index for a possible short

  1. Mauricio says:

    Fascinating post! I think your analysis was extremely insightful and generous. I also think that VXX might be a 5th degree derivation rather than 4th since the the S&P 500 index is technically a derivative of its component stocks. What I mean is that there are many ways to construct an index depending on the type of averaging method employed.

    Keep up the good work!

  2. jrv says:

    Thanks for your appreciation and contribution Mauricio, I edited a bit and changed from 4th to 5th degree, it is indeed reasonable to consider it a 5th degree derivation.

  3. Mike says:

    When you say XVV in your article, do you mean VXX?

    For example:
    XVV is not a vanilla derivative its a 5th degree derivation:


  4. jrv says:

    yes, it was an error, I just corrected it, thanks!

  5. Mike says:

    Thank you!

Comments are closed.