September 11, 2017
If you are a seasoned VIX derivatives trader, ignore this brief post. This is intended for the investor or trader that has recently stumbled upon VIX derivatives or doesn’t understand them in depth.
There are numerous misconceptions related to the products VXX and UVXY. I will outline them, briefly, and describe how these products will approach zero in the long run. In addition, I’ll explain a better alternative.
Contango
Contango is the term used to describe the % difference between the first and second months of the VIX futures term structure. This value is a strong indicator of current market conditions. When the VIX futures term structure is in contango, it means that VIX futures are more expensive two months out versus one month out. Because of this, VXX will almost always lose money (in the long term). VXX holds a collection of first and second month VIX futures contracts. As days pass, VXX must begin to buy more of the second month and sell more of the first month (it is constantly rebalancing its holdings).
Roll Yield
This will explain why the term structure causes VXX to consistently lose value. Roll Yield is the difference between spot VIX and the first month of the VIX futures term structure. Roll yield is the term used to describe the convergence of those two values when the future is due to expire. Because nearer term volatility is less expensive (spot VIX is usually less expensive than month one of the VIX futures term structure), the future will typically have to drop in order to converge with spot VIX. This causes VXX to lose value consistently, as VXX is long those same futures. Essentially, VIX futures have a strong negative bias that is always acting on them, which will prevent holders of UVXY and VXX to lose money on a consistent basis. Obviously, there will be exceptions.
XIV
You guessed it. If VXX and UVXY suffer from those characteristics, then the inverse would benefit. That’s 100% correct. XIV benefits from contango and roll yield, making it a much more attractive profit.