Hey Traders,

As most of you know, I’m a volatility geek.

I was in the room when the Cboe Volatility Index (Ticker: VIX) was but a concept, so I like to think of myself as a “helicopter parent” of sorts, keeping close tabs on — and often making money on — Wall Street’s “fear index.”

In fact, I have a proprietary Traffic Light to let me know when it’s a good time to speculate on volatility or put on a hedge (which can be expensive). 

So if the VIX has been like a kid to me, perhaps that makes me a grandparent of sorts to all the VIX offspring, including the iPath S&P 500 VIX Short-Term Futures ETN (Ticker: VXX).

And after the close last Thursday, April 22, the VXX — which essentially allows traders to speculate on the short-term direction of the VIX — underwent a 1-for-4 reverse split.

So today, I’d like to give a brief primer on what the VXX is, what the reverse split means and why it happened, and how NOT to trade the volatility exchange-traded note (ETN). 

VXX in a Nutshell

Let me begin with this, because it’s important: 

If you want to get really comfortable trading VXX, you should understand the following three things, which I discuss frequently in my Volatility Edge program:

1. 1. 1. 1. VIX cash and futures
         2. Implied volatility (IV) and VXX
         3. Contango and backwardation

HOWEVER, I recognize that volatility products can be extremely intimidating for new — and even old — stock and option traders.

They’re complex and convoluted, and words like “contango” and “backwardation” can send even the most seasoned speculators into a coma.

So without getting too bogged down in the nitty-gritty, here are a few things to know about VXX and its split …

VXX is machine-like in its operation — every day, it’s basically selling a front-month VIX future, and buying the next-term VIX future.

On a day-to-day basis, the VXX can go up or down quickly, and is heavily correlated to the actual VIX.

In the long-term, though, VXX goes out of business slowly.

VXX, by nature, is a downward-sloping vehicle, pretty much constantly headed to zero in the face of time decay.

Barring some wild market event that spooks Wall Street and bids up VIX options — like the beginning of the pandemic in late February 2020 — VXX charts usually mimic the trajectory of a skydiver jumping out of a plane.

Daily chart of VXX – courtesy of StockCharts

And BECAUSE VXX is in a virtually constant state of decay, it undergoes regular reverse splits to keep it from actually hitting $0.

Trading VXX (Or Not)

All that said, one would never want to “own” VXX — it’s certainly not a long-term buy & hold trade.

That would basically be like buying a 30-delta put option every month, letting its value decay to $0, and then rolling it to the next month’s series.

But if you understand term structure and how to estimate VIX futures, VXX can be a great vehicle to place short-term bets on volatility.

If I wanted to short volatility, for instance, I could buy VXX put options … 

Or I could buy VXX call options if I think VIX futures are headed higher … though there are ways for the VIX to go higher and a VXX call option to still lose value.

However, if I see the stock market AND volatility products rallying in tandem, that tells me that volatility traders are scared … and vol money is usually smart money, in my experience.

So sometimes, the best VXX trade is nothing at all …

In closing, the VXX is typically pretty predictable in its path lower, but the best way to ride this volatility product to short-term profits is to take the time to understand it.

Find yourself a Volatility Lifeguard like me or my colleague Andrew Giovinazzi, and let us teach you the math behind the VXX movement … it’s probably a lot easier — and more profitable — than you think. 

Your Only Option,

Mark Sebastian