iPath S&P 500 VIX Short-Term Futures ETN VXX
November 18, 2010 - 9:12am EST by
2010 2011
Price: 48.08 EPS $0.00 $0.00
Shares Out. (in M): 19 P/E 0.0x 0.0x
Market Cap (in $M): 913 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 913 TEV/EBIT 0.0x 0.0x

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This write-up is a follow-up to Hkup's outstanding VXX short write-up from early this year. I think that this short is in many ways more attractive now, partly because of material change that has occurred since his write-up- the fact that VXX is now optionable.  You can refer to Hkup's write-up for a discussion of the reasons why VXX decays over time when VIX is in contango..and I'll also give a brief primer on that issue below.

VXX suffers from negative roll yield when the VIX is in contango (when the front month VIX futures are less expensive than the second month futures), with the result that VXX loses value each day due to rebalancing. This is why VXX is not able to sustain its value the way the VIX does.

The negative roll yield results from 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 December futures and the January 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 December 22 next month (see  http://www.theocc.com/components/docs/about/publications/xcal2010.pdf), which means that at the close of business on the day before expiration, December 21, VXX will hold exclusively the January VIX futures . As each calendar day passes, VXX will sell 1/20 of the December VIX futures position and buy an identical amount of the January VIX futures.

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  result in a gain.

VXX has constantly been in a very large contango for the last 6-7 months and I don't anticipate this changing any time soon (though, if this were to change dramatically, it could definitely adversely affect this trade)

 There was a whopping $3.05 difference between the December and January VIX futures settlement prices as of today's close, as December closed at 22.30 and January at 25.35.  To calculate the currently monthly erosion for VXX, I divide that $3.05 contango by the December VIX settlement of 22.30 and I get 13.5%.

The bottom line is that, for as long as the current contango remains in place, VXX will erode roughly 13.5% every calendar month. Put another way, you have roughly a 13.5% "head start" on the short at current contango levels

 Multiplying 13.5% times VXX's closing price today of 48.07 gives us  $6.49. This means that, were VIX and VIX contango to stay right where they are now, VXX would likely trade in the $42 range by the end of the December VIX cycle on December 21 .

 Of course it is certainly possible that VIX moves up significantly from here and stays at elevated levels..but it's not possible for VIX to move up enough over the long term to offset the massive slippage VXX will experience month after month (13.5% per month, every month) if contango stays anywhere near as large as it is now. Even if the contango narrows enough that the slippage is "only" 10%, that's still a massive edge on this short.

 This all sounds too easy, right? "What's the catch?", you're probably wondering. Well there is one- the catch is that in the event of a huge volatility spike (such as the one we saw with the "Flash Crash" this year) VXX can and will spike massively..and, in that event, a naked short position in VXX can be extremely painful short term...and even expose the holder to margin call risk if they are short in too much size. For context, VXX moved up around 55% in a straight shot in May after the "Flash Crash" and even bigger moves are possible in the event of truly horrible market/world events.

 So what I'm recommending is shorting VXX at  today's closing levels (around 48) and buying December $60 calls at around .60 for a hedge. This accomplishes two things- first it limits the total maximum loss to around $12.60...and second, by taking crushing downside risk off the table, it allows one to put this position on in significant size and still sleep at night.

 In the event of a truly extreme volatility event like the Flash Crash,  the play I'm recommending would likely result in the maximum loss of $12.80..as VXX would likely trade over $60..and VIX would at least briefly go into backwardization..which would kill the "edge" here for as long as the backwardization persisted. That's the risk here (if there was no risk whatsoever, then this amazing risk/reward opportunity wouldn't exist). Otherwise, I think that the risk/reward with this trade is outstanding. Even in the event of a large VIX spike that doesn't alter the large contango (for instance we just saw such a spike on Friday and it didn't affect the contango at all) the trade still makes sense. Were VIX to spike very hard again and the large contango still remained intact (which is entirely possible as we just saw on Friday), my recommendation would be to keep the VXX short on (even though it would be a loser short term) and buy January $60 calls and wait for the inevitable erosion to make the VXX short trade profitable.  The only reason to abandon this short would be if the large contango were to go away and not return (and I'm not convinced that this will ever happen. Certainly it didn't happen after the Flash Crash as the backwardization only lasted a couple of days then...and was quickly replaced by a large contango). Otherwise it is an almost inevitable long term winner imho, pared with the protective call hedge.


Inevitable decay
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