Thursday, May 7, 2009

VXX Calculations, VIX Futures and Time Decay

As I type this, the VIX is up about 6.5% for the day and VXX is only up about 2.0%.

While it looks like today is a good day to be long volatility, getting 4/13 of the move in the VIX with a VIX ETN does not look like an efficient way to play the volatility trade. In fact, I have discussed the issue of what I call the VXX juice factor on a number of occasions and have concluded that on average, anyone owning VXX should not expect to capture more than 50% of the move in the VIX, at least based on data since the January 30th launch of VXX. Going forward, however, 40% might be a more realistic target.

A reader asked about the extent to which VXX returns may be adversely impacted by time decay, rolling and other issues.

When it comes to VXX price erosion, there are two primary factors to consider. The first is the mean-reverting tendency of the VIX and VIX futures. The second factor is the daily rebalancing of the two VIX futures that are utilized to calculate the value of VXX.

The VXX calculation is derived from the two nearest months of VIX futures. At the moment, this means the May futures and the June futures. For the sake of simplicity, I will refer to these as the front month and second month futures. I’ll explain the calculation with an example.

VIX options expire on Wednesday, May 20th this month (see 2009 expiration calendar), which means that at the close of business on the day before expiration, May 19th, VXX will hold exclusively the June VIX futures (VX-M9). As each calendar day passes, VXX will sell 1/23 (there are 23 trading days in the current VIX options expiration cycle) of the June VIX futures position and buy an identical amount of the July VIX futures, so that the percentage holdings of the front month and second month futures always create a synthetic blend of a basket of VIX futures with a constant maturity of 30 days. [Note that this is different from the calculations of the cash VIX, where the front month and second month options roll forward one month 8 days before VIX options expiration.]

As long as the near month and second month futures are similar in price, the daily rebalancing has little effect on the price of VXX. When the term structure has a steep slope and there is a substantial difference in price between the front month and the second month (as was the case with SPX options on 11/20/08), the daily rebalancing can generate its own profit and loss. As the graphic below shows, there was a 0.75 difference between the May and June futures settlement prices yesterday. Calculating 1/23 * 0.75, yesterday’s daily rebalancing probably resulted in a 0.03 change in price.

In terms of pricing implications, when VIX futures are in contango (upward sloping over time, second month more expensive than front month), there will be a daily loss of value due to rebalancing. On the other hand, when VIX futures are in backwardation (downward sloping over time), the daily rebalancing process will generate a gain.

Following the launch of VXX on January 30th, VIX futures were consistently in backwardation until the beginning of April, at which point the term structure flattened out. At present, there is some slight contango that could adversely impact VXX prices going forward. Technically, this rebalancing is called "roll yield" and when the roll yield becomes negative, VXX prices will suffer daily losses as a result.

For more on this subject I recommend Standard & Poor’s white paper on VXX returns: Directional Exposure to Volatility Via Listed Futures

For more details on VXX, iPath has two documents worth checking out:


[graphics: FutureSource]

Disclosure
: Long VIX and VXX at time of writing.

8 comments:

stonebat said...

yeah... contango issue. no luv for vxx. it doesnt even look like good hedging tool. spike in vix must exceeds market's expectation for vxx to become truly hedging tool. if vix stablizes... vxx will continue to slide because of the rollover cost.

vix options is better hedging tool. im still waiting for vix to go below 30. 27.5? 25?

technicals might flash very strong sell or buy signal all over... but i just need to keep my power dry. you know... let it run for a while. there must be millions of investors like me who spotted the strong signal. i really hope they did... because i always wanna be standing next to them. but they could have been the other side of the strong signal when they spotted it. they gotta pump or plunge the markets to close their current positions and switch to the other side. sometimes it takes as short as a day... or as long as a couple of months. the current rally has been very strong. so i expect it should take AT LEAST a couple of weeks. suppose this is the first week of the unwinding process. next week is 2nd... and its OE week. then the following week is 3rd.

theres... really no reason to hurry and take a position as soon as fresh new trading signal is flashing.

Anonymous said...

I am a huge fan of this blog. However, I do not think that contango and backwardation affect the VXX. The rebalancing is done such that an equal dollar amount is rolled over. For example, if one month vix was 40 and two month vix was 20, then two units of two month vix would be purchased for every unit of one month vix sold. As long as hypothetical one month vix remains at 20 and two month vix remains at 40, the VXX should not change. The prospectus confirms this calculation methodology and also states that it was designed to prevent contango/backwardation from affecting the VXX price. Thanks for all of your useful help on this blog.

Bill Luby said...

Thanks for the interpretation, anon. I'll have to read the prospectus again for a third time. The methodology was not clear to me after the first two passes.

Cheers,

-Bill

stonebat said...

i disagree with anon. the contango could diminish NAV of the futures based etfs. this is really nothing new... try USO forums and read all about contango issue they had since last year. USO at the current price last year had much lower crude oil spot price. although the futures based etfs are not explicitly leveraged, they could lose NAVs over the time just like leveraged etfs.

Guru said...

Bill, I overlaid VXX on top of VIX and found that, over the long-term (from Feb 1 to yesterday), the two tracked fairly closely (see http://tinyurl.com/VIX-VXX-Comparison). While on a daily basis the you may lose with the VXX as compared to the VIX but the gap is closed if you are able to hold long enough.

If the VIX starts going up (to say 40) then wouldn't it be far to say that VXX would ultimately catch up before the VIX turns back down?

What am I missing here?

Bill Luby said...

Guru,

Good questions.

The short answer is that in February and part of March, volatility was doing very strange things and the VIX futures were in an unusually strong backwardation position for a fair amount of the time, which is rare.

In the last 6 1/2 months, the VIX futures reverted to their more normal contango relationship. During that period, the VIX has fallen 39% while VXX has fallen 60%. My contention is that the February to March period will turn out to be a historical anomaly.

Cheers,

-Bill

Robert said...

Historically the VIX term structure is upward sloping so VXX will lose value over time.

Are there any uses for VXX beside speculating on the short term VIX changes?

You can use VXX to delta hedge your short VIX call option position.

See: http://volatilitysquare.blogspot.com/2010/02/vxx-and-term-structure-of-vix.html

Bill Luby said...

Thanks for the comment, Robert. By the way, your blog is off to a great start and promises to be a must read for all serious students of the VIX.

Cheers,

-Bill

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