Spooky. Everyone gets so freaked out whenever someone brings up the word volatility. Wall Street and financial media have successfully scared everyone with their doom and gloom sales tactics.
However, there is a time and place for trading volatility and some of the volatility instruments. VXX is an excellent way to get exposure to trading volatility as it has a lot smaller margin requirements than simply trading the VIX. Because there is something interesting going on with VXX that not a lot of people know about, we recommend trading VXX options as opposed to the stock. Let’s get to work.
What is VXX?
For starters…what is the $VXX. Well…the medical term is the Barclays Bank PLC iPath S&P 500 VIX Short Term. Some people know it as the VIX ETF. Others know it as the 2x VIX. We just know it as VXX :).
Yes, the VXX is a volatility product that does have somewhat of two times the movement of the VIX or volatility. However, this is where it become different.
VXX is priced by the VIX futures. This means there is no physical product and the price of VXX is reflected by the price of a combination of different VIX futures contracts. Let me explain.
Barclays manages VXX. Every day, they sell futures in the front month and buy futures in the back month. Why do they do this? They do this because the VIX futures have expiration dates and they need to keep VXX chugging along so they cannot let the futures contracts sit there and do nothing by expiring. They have to roll them out to the next month. Every day they do this so that less and less front month VIX futures are in the bundle that created the price for VXX. Again, this is to keep VXX alive.
Now we get to the fun stuff. If Barclays needs to sell futures in the front month and buy them in the back month…it looks like they will be selling futures that are priced lower than the futures they will be buying. We call this contango.
Contango is the concept that in futures contracts, the back month price is higher than the front month, and this phenomenon occurs 80% of the time. This means that 80% of the time, Barclays is selling futures at a lower price than they are buying with decreases the value of VXX. What a raw deal as they are taking a loss for doing so.
This is why we recommend not trading the stock for VXX. We never suggest buying it as we know 80% of the time is has a negative drag to it because the VIX futures are in contango. You also might be saying, “Let’s sell it!”. That is a great idea, but this is such a good deal that VXX is none to borrow which means there is no stock to short.
We can see the VIX in green/red staying steady as VXX in the pink goes down and down and down.
And even worse yet, this is what VXX looks like over the last three years.
This keeps going down and down and down. And no, your eyes aren’t bothering you. That is $192.68 down to $16.76. The only reason VXX hasn’t gone to zero is because it keeps issuing more shares in a reverse split.
We want to trade VXX from the short side for obvious reasons and we cannot borrow any stock to get short. So what do we do? We trade VXX options!
Trading VXX Options
Luckily for us, VXX options are heaven. Let’s check it out.
For starters, VXX trades hundred of thousands of options contracts per day. Incredibly liquid. With this many options, the total notional value traded for VXX options yesterday was $488,508,489. Big boy numbers. And as always, with volume this high, the options market must be beautiful.
And they are. There are monthly and weekly expirations making this an exceptional trading vehicle for any date and time. How about our markets tho?
Beautiful. This checks everything off our list:
- Penny wide bid/ask spreads…check
- Volume in the thousands…check
- Open interest in the thousands…check
But because VXX has a negative drag to it 80% of the time due to contango in the futures market, we only want to trade from the short side. Fortunately, VXX options are so liquid they allow us to do whatever we want from the short side. We can trade any spread we want as well as naked options (cheap stock price = low margin requirements).
What is our favorite trade in VXX options you might ask? We like to sell the at the money call spread after VXX goes up a little bit :). We sell one call and buy another call above it to define our risk.
VXX Options…Add Them to Your Arsenal
If you do not have VXX on your watch list, add it now, please. Yes…get up…and go add it.
Fortunately for you, you now know how to not get suckered while trading VXX.
And remember, we only trade VXX options because:
- There is a negative drag 80% of the time
- There is no stock to borrow to get short
So we trade these liquid options that have massive amounts of volume and interest…only from the short side.