The iPath S&P 500 VIX Short-term Futures ETN (VXX US) tracks the performance of the front two-month CBOE Volatility Index futures contracts. As we get closer to the expiration of the earliest contract, more of the underlying ETN’s investments fall into the latter of the two futures contracts – this is the ETN’s continuous “roll” into longer dated futures contracts.
Because the VIX futures contracts usually trade in contango, the price of futures contracts gets more expensive the farther out its expiration date, and this roll is inherently a money losing transaction. In order to deftly and seamlessly “roll” into the next futures contract month the ETN advisor perpetually sells part of the near-term contract in order to fund purchases of the longer term contract. If the near term contract is in contango, and therefore cheaper than the far term contract, the advisor can only afford to buy fewer contracts of the far term contract. One of the main reasons for the pricing discrepancy between the two contracts is that the time decay of the near contract is larger than that of the far term contract. Therefore, over time, the ETN loses value. Even if the underlying VIX index is trading in a tight range and is in contango, the VXX ETN will show disparate losses because of its constant money-losing “roll.”
The other side of contango is backwardation, where the far term futures contract is pricing at a discount to the near term futures contract. In this case the VXX ETN’s “roll” will be profitable as selling the near term contract will generate more funds than used in buying the far term contract. The excess time decay issue of the near term contract still exists but is usually offset by the amount of the backwardation premium.
VXX short sellers have taken advantage of the VIX index contango to make outsized returns in the VXX ETN. From 2016 through 2017 short sellers have made $690.3 million, a 75.83% return, on an average short position of $911 million. This P/L includes an average stock borrow fee of 2.95% for the last fifteen months, for a total financing cost of $16.7 million.
In a time when VIX volatility is at record low levels, traders are feeling no trepidation taking short positions in the “fear index.”
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