VXX And VIX - Volatility And Dynamic Hedging (2024)

I've recently authored three articles on ways to trade volatility through the VIX and the iPath S&P 500 VIX ETN (BATS:VXX) (here, here and here). I suggest any reader that hasn't read them, to please read them as an understanding of their concepts is vital to an understanding of what I'm about to present, here.

But, given the fact that most readers just plow head-long into an article, I'll repeat the salient pints:

VIX

VIX, the "fear gauge" mean reverts around a value of approximately 20. That means when it is above 20, it will eventually fall back down and when it is below 20 it will rise. Maybe not immediately, but eventually.

In my first article I meticulously laid out how to capitalize on this characteristic of VIX through various option strategies that go net short when VIX exceeds 20 and net long when it is below 20. Classic "buy-low-sell-high".

VXX

VXX is an ETN that is used, primarily, to day trade (or short-term trade) VIX. It tries to replicate VIX by purchasing futures. For those unfamiliar with how futures work, think of the strategy as buying at-the-money (ATM) call options each month. This is pretty effective for short term trades.

However, for long-term holding it is a disaster. Continually buying calls works if the underlying continually goes up. But, VIX doesn't go up, it mean reverts... it oscillates around 20. Going up and then going down. The long-term result of going long on a vehicle that oscillates between ups and downs is that VXX decays and loses value over time. It has been estimated that this decay is as much as 5% per month.

Here's a graph, courtesy Fidelity Investments, that illustrates the difference between VIX (mean reversion) and VXX (decay) for 2021 year-to-date

Well, anytime one is given an investment that loses value, it is ripe to short. That's exactly what I suggested, using call-writes instead of an outright short.

One thing of particular note ... if you study the chart you will notice on big spikes up, VXX doesn't climb as much as VIX. For instance, in January VIX spiked about 70% while VXX spiked only about 25%. Again, in May VIX spiked up about 50% and VXX only about 12%. The pattern is repeated time and again.

So, we can conclude that VXX is a "safer short" than VIX for two reasons:

1) It decays over time,

2) Because it decays over time, when it does spike it is generally less volatile

Dynamic Hedging Choice #1

In the "good old days", before hedge funds proliferated, before inverse ETNs existed and when options were less sophisticated, hedging had a different flavor. Investment managers would look to find two similar companies (such as Coca-Cola (KO) and PepsiCo (PEP)) do their analysis and hopefully discover a "winner" and a "dog". They would then short the "dog" and buy the "winner".

If they were right in their picks, and the "winner" outperformed the "dog" by either going higher or falling less, they made the spread. This is a very simple concept, provided one had the skill to find a "winner" and a "dog". If they got it wrong, they lost the spread.

Now, with VIX and VXX, we have two similar yet different vehicles. Similar in that they react to volatility and different in that one reverts, and one decays. Furthermore, the difference becomes greater at longer time durations.

So, when it comes to VXX and VIX ... we know who the "dog" is ... it is VXX.

So, Dynamic Hedging would go long VIX and short VXX. Let me put it into numbers.

Here’s a chart that shows call option details for both VXX and VIX (courtesy Fidelity Investments)

Please note that the expiry dates for both are 8 months away… June 2022. The strike is chosen at 80 (a 99.76% chance to NOT be over-run)

So we have similar products (volatility driven) similar expiry (June 2022) and, similar strikes (80).

But look at the option premiums. VXX could sell-bid at $2.32 and VIX bought-ask at $.58.

So, selling VXX call option and buying VIX call option as illustrated would net a credit of $1.74. Now, it's not a lot of money unless one uses a large number of options, but this is for concept.

It's important to note that VIX and VXX are not currently trading at the same level. VIX is around 18 and VXX around 24. So, some disparity in price would be expected. However, this is a far-dated June 2022 expiry and VXX decays. By June 2022, VXX should be at least 30% lower and any disparity would be wiped out.

Now, if the expiry was near-term, the decay isn't as great and the disparity is more meaningful. That's why I picked, as my expiry, the farthest dated option VIX trades under.

Now, as to risk, practically ZERO. The only possibility of loss is if VXX went above 80 and VIX did not. But we've seen that the decay actually causes the opposite to happen .. VIX spikes higher than VXX.

Furthermore, VXX decays and in 8 months' time it could deteriorate by 30% or more and have an even higher hill to climb.

Dynamic Hedging Choice #2

Let me share another variation of the Dynamic Hedging... the ratio hedge. Here’s another option chart (Fidelity Investments)

Please note that, once again, a June 2022 expiry .. only this time the strike is set at 40.

The premium credit for VXX is $4.75 and debit for VIX is $2.32 … a 2:1 ratio.

Now, one could do as I previously described and look to earn $2.43 per option .. but I have a variation.

Instead of looking to make a spread, consider being revenue neutral and buy twice as many VIX calls as they sell VXX calls.

For instance, one could buy 10 VIX calls for a debit of $2,325 and sell 5 VXX calls for a credit of $2,390 … for a net ZERO outlay.

Now, why would one do this? Simple, to be NET LONG VOLATILITY. To protect a position from a big spike in VIX.

This could be used to hedge an otherwise short position in either VIX or VXX.

Let me give an example: Let’s say you wanted to short 5 slightly ITM calls on VXX for June 2022.

Here’s what the option chart tells us:

A short at 20 strike credits $8.32. That represents a 30%+ premium to price.

With normal decay on VXX, we have reasonable expectations of profit. But, because VIX is currently at 20 (its mean) a spike is a real possibility.

However, by combining the naked short with the 2:1 ratio, we limit potential draw down. if there’s a spike, we are NET LONG 5 VIX options at 40. This should offer protection to cover any ultra-large move in VXX.

Now, if one wanted even more safeguard, they could buy, say, 14 VIX options and sell 7 VXX options, once again, revenue neutral, but 7 NET LONG options.

Dynamic Hedging Choice #3

Just one more example of what can be done. I call it "staggering strikes" Here's another Fidelity chart:

What you will notice in this one is I compare a VXX call-write at a strike of 45, to a VIX call-buy at a strike of 30. The premium debits and credits are neutral.

So, VXX would have to exceed 45 at the same VIX only reaches 30 for any loss to occur. Given the inherent decay in VXX, this is extremely unlikely. In fact, history tells us that VIX has a better chance of reaching 45, then VXX. And, if VXX somehow spiked higher than VIX it would be ripe for arbitrage.

If VXX does reach 45 or above, VIX should be at least $15 ITM, plus cancel out any rise in VXX above 45.

Portfolio Protection

Utilizing a ratio of VIX to VXX with a June expiry can also act as a form of portfolio protection... irrespective of any VIX or VXX option position.

I wouldn't necessarily go as high up as VIX=40, as that's pretty rare. Here's a chart for June 2022, with strikes of 25.

One can see that the premium for VIX is $4.85 and for VXX it is $7.05. So a 2:1 ratio that worked at a 40 strike doesn't work at a 25 strike. Instead one would have to use a 7:5 ratio. Not ideal, but it's an option worth considering .. especially if one is otherwise aggressive with their investments.

Otherwise, one can use the "staggered strike" to offer some protection.

Summary

VIX and VXX are interesting vehicles. VIX mean reverts and VXX pretends to mimic VIX... and in the short run, it does, but in the long run it just decays.

What is of value is the comparative option pricing of the two vehicles. In the long run they are as disparate as the vehicles themselves. This disparity can be "played" in a variety of ways through Dynamic Hedging. Is it without risk?... of course not... but the risk is so minimal compared to the potential reward it is hard to overlook.

What I have presented in this article is a methodology to exploit their differences. In addition to the methodology, I've presented some working examples. I encourage readers to "play with" various expiries and strikes and find what fits most closely into their strategy.

Now, let me state that if VIX and VXX spike up early (well before June 2022) and drop back down, Choices #1 and #2 do very little... unless, that is, the move back towards mean reversion is slow and the residual from the spike remains. So, for these choices, it is insurance against a slow, painful recovery after a spike. If, on the other hand, the mean reverts quickly, then the trades I suggested in previous articles are winners.

Reel Ken