Using VXX to Get through These Volatile Markets

(VXX A-) is a short-term futures exchange-traded note (ETN) that’s designed to provide investors exposure to the S&P 500 (VIX). VIX is the most popular measure of investor sentiment and market volatility (as conveyed by S&P 500 Index option prices). But why would anyone want exposure to volatility? (Read: shouldn’t we stay away from a volatile market?) If you are not heavily invested in the market, it’s not a bad idea to wait out the volatile period. But what if you are in the market and need to protect your portfolio against volatility? Waiting or selling off your portfolio and then rebuilding it later could turn out to be expensive. Exposure to VIX can help investors hedge portfolio risk or even gain from the volatility itself.

Some things need to be mentioned loud and clear. VXX doesn’t make its way into any casual, hands-off investment guides. Since its inception, VXX has lost more than a whopping 99% of its value. That’s more than a 50% loss of value every year since it started trading in January 2009. And the loss in value is not because it’s the worst security ever invented but primarily because of what is known as negative roll yield. Without getting into technicals, it is a loss that happens because of the underlying instruments the note tracks. We will come back this point later. For now, let’s take a couple of steps back and get a bit of background.

To understand VXX, one needs to understand a bit about VIX. As mentioned earlier, VIX is a popular gauge of volatility and is often referred to as the “fear index.” It uses near-term option prices to calculate the “implied” or expected volatility of the S&P 500. Why this specific method? Options are a good indicator of what traders think is going to happen in the short term. For example, puts (the right to sell at a certain price) outweigh calls (the right to buy at a certain price) when the expectation is bearish. If the spot price of a stock is $50 and there is a lot of interest (investors are paying a high premium) in buying a right to sell the stock at $40 a month down the road, then the market situation is surely fearful. The Chicago Board Options Exchange (CBOE) used this logic to figure out a way to combine the prices of near-term calls and puts and come up with something called a Volatility Index or VIX. Since these options are based on betting where the S&P 500 will be in the short term, the volatility measurement is considered more or less representative of the market in general.

Now let’s look at VXX. It’s an ETN that has a close relationship with VIX. I say it has a “close relationship” with VIX rather than “tracks VIX” because VXX invests in VIX futures. This is because you can’t invest in VIX directly. Now, because they are futures, they expire and new ones need to be bought (rolled over) to continue the relationship with VIX. This is one of the reasons why VXX keeps losing its value over time. We referred to this negative roll yield earlier on. For more details on why investors lose money while rolling over to newer contracts, read What is Contango?

In very simple terms, VXX tends to go upwards when there is increased volatility. A recent example was in the month of August. Bad news dominated the markets worldwide and it was fairly obvious that there was plenty of panic. VXX rose sharply as SPX (the S&P 500 Index) declined. Investors could have employed other strategies during this time, like buying inverse ETFs, buying puts, selling futures or using multi-leg derivative strategies. Holding (SH A+), the inverse S&P 500 ETF, for a few days would have been a good idea, too, but the returns would have been fairly modest compared to VXX. If you are quick and active, this is a good tool to have.

This is a high-risk investment strategy and not a good idea if you are not actively tracking the markets (especially if you’re not tracking technical indicators). VIX is not perfect and as an additional level of complexity VXX is not perfect in tracking VIX. Since this would be an investment not in assets but rather in market sentiments, investors could lose a lot of money despite their best research. If you bought VXX towards the end of August (and there were good reasons for it), you would be down about 20% today.

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