Like the (head) wind

The Option Pit VIX Light Is Red, and Volatility Will Drop.

Hey Traders,

The VXX is an ETP that holds VIX futures.

The basket of futures VXX holds have a constant duration of 30 days to expiration … So it’s always 30 days until expiration for those futures — today, tomorrow and in a year.

But how does VXX keep that constant?

The answer is simple — every day it rolls out of near-dated futures contracts and buys longer-dated futures contracts.

So, on the day VIX futures expire, the VXX is carrying 100% the next month out.

For example, when April VIX futures expired on Wednesday, April 21, VXX was carrying a portfolio that was 100% May VIX futures.

Why? Because those futures had exactly 30 days to expire.

The next day, when the May futures had 29 days to expire, the VXX sold a small portion of its holdings in May and bought June futures.

Why is this important?

Because this rolling is what creates the headwind.

Let me show you graphically.

This is a picture of two VIX futures curves. The blue is Tuesday’s settle; the green is the futures curve from April 19.

The VIX itself closed $17.56 on Tuesday. At expiration, the May futures will eventually converge with VIX.

Now, take a look at the May dot plots. What happened to May futures from April 19 to Tuesday? They dropped.

Not all at once mind you, but a little bit each day.

Over that period of time, VXX began selling those futures to buy June.

As that happened, every day, VXX was selling its existing May futures position, the one that started at $20.65  and by Tuesday had fallen to $19.85.

The .80 that decayed out of the May VIX future, even as VIX was relatively stable, is where the headwind for VXX is created.

By calculating how much time there is to expire, and where the current VIX is trading,  my team can calculate exactly how much VXX should lose each day, assuming that the VIX does not move.

If the VIX goes up, the loss to VXX will be less — or VXX could even go up.

If the VIX goes down, VXX can lose even more.

Basically, on a daily basis, VIX can determine the direction of VXX, but over time, VXX is 100% driven by VIX futures term structure.

So, when I said VXX has a $5 headwind, we figured this out by calculating where VIX futures were trading and how much they needed to drop between yesterday’s date and expiration.  

In addition, we take into account the rolling that  occurs and adjust the daily decay as the basket changes from heavy May futures to more and more June futures.

My Trade

Now to my trade …

I hope you can see why I like my put spread so much.  

Using the calculations I have on roll,  I can basically throw out my normal VIX biases, and simply go long a near the money put that has high odds of ending up deeply in the money,  

I then sell a put that has much longer odds of VXX decay hitting it.  This mitigates some of my risk of a VIX rally (I can buy back the VXX 35 puts if VIX does pop for cheap) and reduces my cost.

The Option Pit VIX Light Is Red, and Volatility Will Drop.

Your Only Option,

Mark Sebastian

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