If you looked at my previous posts, we tried to track the trail of the VXX and what it really means. My first trade on the VXX was in Q4 of 2011, when I decided to short or sell at the money calls on the VXX. Fortunately, the VXX is a pretty liquidity security and the options trade as well.
Why would I do that? When you sell options, you are “short volatility”, i.e. if volatility lessens, you are winning. So, if volatility on the VXX decreases, the option should be worth less, thus benefiting my short position. I am shorting volatility on an index that tracks volatility. Double bang for the buck!
So let’s think this through. Let’s say the movement in the S&P becomes normal, or some would say boring. Options on the S&P become cheaper, as volatility is lower due to the stability of the market. Prices of futures on the VIX goes down, alongside volatility, as expectations of options volatility also goes down. The market is calm and steady. The VXX, which tracks the futures, also trends down, and does not move up and down with any particular velocity. Hence, the calls that I’ve shorted decline in value, due to lower volatility in the market, and the VXX is less volatile, and the value of my calls go down due to contango.
The inverse should be true. If I buy calls, and the S&P starts to gyrate, the VIX moves upwards, and hence the VXX moves higher but in a volatile fashion, then I should get a double bang for the buck on the upside! Volatility is higher. Volatility of the VXX is also higher. Calls are higher. But, I still have the pesky contango issue.
Also, I have a lot of time value working on my side, which I’ll explain in a subsequent post, as I also discuss contango.
Okay, VXX is in Contango. Expect 3% monthly declines in the product. This is au naturel! Of course, as a reminder, when the markets go crazy, VXX could pop and as my friend Vincenzo says, “you can get your face ripped off!”