VXX is designed to provide investors with exposure to the S&P 500 VIX Short-Term Futures™ Index Total Return. The S&P 500 VIX Short-Term Futures™ Index Total Return (the “Index”) is designed to provide access to equity market volatility through CBOE Volatility Index® futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500® at various points along the volatility forward curve.
Excerpted from The VXX Trend Following Strategy:
Before you start trading VXX, or any other volatility instrument, it’s useful to have a basic understanding of how it actually works. At a very high level, the price of VXX is determined by the price of VIX futures contracts. VIX, in turn, is calculated using SPX option prices. Let’s start at the bottom and work our way back up.
SPX is the ticker symbol for the S&P 500 Index developed by the Chicago Board Options Exchange®, commonly referred to as the CBOE. Because it is an index, you cannot trade SPX directly. However, the CBOE offers cash‐settled options on SPX which are traded daily at high volumes. If you’ve studied options at all, you probably realize that there are three major components that determine the price of a specific options contract:
- Intrinsic value is the difference between the strike price of an In‐The‐Money (ITM) option and the price of the underlying security or index. Call options have intrinsic value when the strike price is less than the underlying price; put options have intrinsic value when the strike price is greater than the underlying price. Out‐of‐The‐Money (OTM) options have an intrinsic value of zero.
- Time until expiration. Options that expire sooner will generally be cheaper than those that expire later. This makes sense, because later expirations allow more time for price movement in the underlying security or index.
- Implied Volatility. The more underlying price volatility that the market expects between now and the expiration date, the higher the option price will be.
We noted above that OTM options have no intrinsic value. Therefore, if we know the currently quoted price of an OTM options contract and the time until expiration, then we can use simple algebra to determine implied volatility. The important concept here is that we’re using concrete data like price, time, and other minor factors like interest rates to solve for the more nebulous concept of implied volatility, which reflects market expectation. Do not confuse implied volatility with historical volatility, which measures the variance of actual price movements over some look‐back period.
Now that you have a grasp of implied volatility of SPX options, you can begin to comprehend the CBOE Volatility Index®, or VIX, which was introduced in 1993. Although the exact method of calculating VIX has changed over the years, the intent has remained the same: to measure the market’s expectation of 30‐day implied volatility. The CBOE states that the current VIX formula “estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices.” Our take‐away here is that VIX represents implied volatility for the S&P 500 over the next 30 days, expressed as an annualized number. In other words, if VIX is currently at 18, that means that the market expects 18% x SQRT(1/12) = 5.2% volatility in the SPX over the next month.
Now that we understand what VIX is measuring, what are the VIX futures? Without going into a lengthy discussion on how futures work, suffice it to say that the price of a futures contract reflects the market’s expectation of the underlying security price on the expiration date of the futures contract. For example, assume that today is June 24th and VIX is at 18. Like options, futures contracts expire the third week of the month. If the July VIX futures are priced at $21.50/share, then that tells us that the market is expecting VIX to rise by 3.5 over the next four weeks or so. The August futures might be priced at $23/share, meaning that the market expects VIX to keep rising over the next two months.
Finally, we can return to VXX. The full name of VXX is the iPath® S&P 500 VIX Short‐Term Futures™ ETN, which is issued by Barclays Bank PLC. The VXX prospectus states that the VXX ETN “is linked to the performance of the S&P 500 VIX Short‐Term Futures™ Index TR that is calculated based on the strategy of continuously owning a rolling portfolio of one‐month and two‐month VIX futures to target a constant weighted average futures maturity of 1 month”. The only new concept here that we haven’t already covered above is the idea of a “rolling portfolio”. It’s really quite straightforward, but will be easiest to explain with another example. Let’s say that today is the day in January when VIX futures expire. At that point, the VXX fund would own a collection of February VIX futures, all of which would have exactly one month until expiration. The next day, VXX would sell a few of the February VIX futures, and buy as many March VIX futures as possible using the sale proceeds from the February futures. This process continues in such a way that when February expiration arrives, all the futures contracts owned by VXX have a March expiration. In other words, the weighted average of the time until expiration of all the futures contracts is always one month.
End of Excerpt
If you would like to continue reading The VXX Trend Following Strategy, a practical guidebook of strategies with clear instructions how to apply entry / exit filters that show historical tendencies to improve the winning edges and average gains of the best systematic strategies to trade the VXX, you can read chapter 1: Introduction to Volatility Trading for free.