Christmas, VIX and the VXX

This is a very, very interesting (and somewhat advanced) blog by Mark Sebastian. And I can not think of a financial web-site where I can find Bob Barker’s birthday thrown in! Enjoy. MK & JW

VXX is one of the more interesting products that are available to trade.  The ETN is so interesting because, on a micro term basis, it is the best and quickest way to track perceptions in implied volatility.  In the long term though, the VXX is heading toward…well you make the call:

The root cause of this slow death comes from VIX futures term structure.  The ‘roll yield’ in VXX, caused by VIX futures contango or backwardation, has a very strong affect on the net returns of VXX.  Do you need more info? The good news is my co-editor at Expiring Monthly and writer of VixAndMore, Bill Luby, has an encyclopedia on this topic available at his website.  Here is a great post that every trader that is somewhat lost right now should read (move on from there if you are still confused).  It is important to understand how VXX operates, because right now, the VIX term structure is quite unique.

As I stated in yesterday’s blog, VIX term structure is quite odd right now.  November and January are priced higher than December.  While this might seem unusual and unexplainable, there is a surprisingly simple explanation for the structure of VIX futures…Christmas.  Christmas you might ask?  Yes, Christmas!

Remember that VIX futures have a really odd expiration that takes place on the Wednesday before 30 days to the next month’s expiration (say that 10 times fast). January 2012 expiration is on January 20th, and this places the Wednesday that is 30 days prior to January’s Expiration on December 21st…AFTER December expiration.  Since VIX will be heading into the holidays at that time, by then, there will be a major weekend time decay effecting options on SPX (read more about that here).  This weekend effect is going to cause an additional crush to VIX of at least 1-2%, which is just how much we need to lift December in order to straighten up VIX structure into a normal backwardation.

Now that you understand WHY this is happening, let’s talk about what effect that could have on the VXX.  As you now know, when VXX is in backwardation, there is going to be some major pull UP on VXX.  In other words, if the VIX futures are unchanged on the day, VXX will be up on the day. This is due entirely to roll yield of the ETN.  Until November rolls off on the 16th, it is going to be very hard for VXX to dive too quickly because of the price action of December.  Those that have been hoping for VXX to enter contango soon, are probably the ‘kings of wishful thinking.’  

If one is expecting the VIX to do nothing in the near term but wants to put on a hedge, the VXX may actually be the better hedge against a portfolio.  For now, the VXX is going to be working FOR the trader instead of against the trader.  If one is expecting a big POP, VIX options are probably better, but for a hedge, I like VXX– at least until November rolls off.  That is the boring part of this discussion, and now we move onto the interesting part…The December and January cycles.

The VXX is set up to get SMOKED between November 16th and December 21st.  It seems that even if the VIX holds up here (something I am starting to doubt), the December contract may trade under January until possibly the final day of expiration.  This sets up the product, as a spectacular short, to lead, not only into thanksgiving, but all the way through St Nicholas day, and all the way through Bob Barker’s birthday on December 12th.  

I would be interested to see if the major market making firms trade VXX options off of the current VXX or from perceived VXX in the futures.  My guess is that a few go with the latter, but it must price off of the former.  This means there is a strong chance that December VXX options are not properly priced in the VIX futures relative to the expected contango.  While the current contango that exists is not a certainty, the Santa Claus Contango should be taken into account.

Going into the holidays, traders should be expecting to short the bananas out of VXX, because it is setting up for an ugly decline.  If VIX starts to fall off, it could be a VXX blood bath pushing VXX back into the low 20’s in a hurry.  One interesting trade might be some sort of Long November Short December play.  One neat idea might be to buy a call spread in VXX and sell a call spread against it in December in order to set up a time butterfly or a calendar swap.

Whatever the play one wants to use, the next few months should be a great study of how VIX ETN’s respond to term structure of the underlying VIX futures.

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Mark Sebastian

COO Option Pit Mentoring and Consulting