During the past couple of weeks, several people have asked me about using VXX as a portfolio hedge. Maybe people feel things are getting a little toppy with all the Fed intervention and the many other harbingers of potential danger hanging over the markets. I wanted to write about this subject because it’s pretty darned interesting and deserves timely consideration.
First things first, let me clarify that my commentary should not be construed in any way as advice. My intention is to teach and get you thinking. By sharing my trading experience and product knowledge, my hope is for you to make educated decisions about how to manage your trading (and hedging).
VIX vs. VXX
That being said, a common portfolio hedging strategy a lot of people ask about is buying calls or shares of (VXX) Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN. For those who don’t already know, the VXX is an Exchange Traded Note (ETN) that seeks to follow the CBOE short-term VIX futures. Conventional thinking holds that VIX futures and options often demonstrate performance that is inversely correlated with the U.S. stock market. Therefore, the thought is that this inverse correlation can offer asset diversification and be considered a good hedge to a generally long-only equity portfolio. So far so good, right? Well, I would be remiss if I failed to mention that using VXX as a proxy for VIX is not a good idea in most instances. Let me tell you why.
VXX ‘Bleed’
VXX does not track the VIX as you might think it would. This is mostly due to the high expense ratio of the ETN caused by what is known as “churn” or “bleed.” The VXX value is based on an algorithm that trades the 14-day and the 40-day VIX future in an attempt to keep the NAV (net asset value) consistent with the VIX index price. This relationship is mandated in Barclays’ prospectus. Every day the administrators of the ETN must legally trade a bunch of futures to get the VXX to line up with VIX, and that trading erodes from the price. It’s a tough endeavor because on top of the commissions they have to pay, Barclays loses more to the futures market makers who set their bid/ask spreads wide in order to take advantage of this known mandated relationship. Sort of a sucker’s bet!
Even more damaging to the VXX NAV than the commissions and bid/ask spread is a major structural flaw that almost guarantees a losing trade. Since Barclays is constantly buying the 40-day future (more expensive) and selling the 14-day (less expensive), they fall victim to what is known as “contango” (a common occurrence in futures markets). Inherently, Barclays buys high and sells low. Last time I ran the numbers, the VXX lines up with VIX only about 80% of the time. This means that around 20% of the time, VXX might be down on the day when the VIX is up. Crazy, right?
ETN vs. ETV
VXX is an ETN (not an ETF). While ETF and ETN sound similar, in fact, they’re quite different beasts. An ETN is a debt instrument with different tax implications. Bottom line is that you should understand every product you trade. Unless you know the details and the nuances of an ETN, you have no business getting involved.
What begins with someone asking me how to efficiently hedge their portfolio usually turns into them feeling relieved for having asked me. A bonus from having had this conversation with me is I get to reveal a great and ongoing trading opportunity that derives from the inherent predisposition for the VXX to “bleed.” I have made this trade so many times over the years I have lost track, and I can count on one hand the number of times I’ve actually lost to it. I suggest you model out the trade I’m going to sketch for you. Conduct independent back testing and draw your own conclusions. Just because it has worked in the past doesn’t mean it’s going to work in the future.
VXX Trading Strategy
When VXX is NOT trading below the average price for the past year, I buy a long-dated put (6-months or so) that is in-the-money. My plan is to sell that put for 10% to 15% profit on a cost-basis within a month or two by betting on this volatility product’s tendency to revert to the mean, as well as lose value due to “churn.” Since explosive upside moves are possible in standard volatility products, I place hard stops out up 60% (just in case) when I execute. How about that for a sophisticated system? I’m telling you right now that with rare and notable expectations, this little gem has won for me multiple times per year, year after year. It’s like the gift that keeps on giving. Thanks, Barclays.
By taking advantage of the curious structure of this popular ETN, it can be possible to lock in significant profits that can more than pay for the alternative of purchasing downside protection for a portfolio. Do your own research and let me know what you think.
Joe Leska
Options Instructor
Market Taker Mentoring, Inc.
