Why Buying VXX Puts Can Be a Profitable Strategy in a Volatile Market
If you are looking for a way to profit from market crashes or volatility spikes, you might have considered buying puts on the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This exchange-traded note tracks the performance of the first and second month VIX futures contracts, which reflect the market’s expectation of future volatility. Buying puts on VXX allows you to bet that volatility will decrease in the near term, which usually happens when the market recovers from a sell-off or panic.
However, buying puts on VXX is not as simple as it sounds. There are several factors that affect the value of VXX and its options, such as the shape of the VIX futures curve, the daily roll yield, and the implied volatility of the options themselves. In this article, we will explain how these factors work and how to use them to your advantage when buying VXX puts.
The Shape of the VIX Futures Curve
The first thing you need to understand when trading VXX is the shape of the VIX futures curve. The VIX futures curve shows the prices of different VIX futures contracts with different expiration dates. The shape of the curve can be either upward sloping (contango) or downward sloping (backwardation).
Contango means that the near-term futures are cheaper than the farther-term futures, which implies that the market expects volatility to increase in the future. Backwardation means that the near-term futures are more expensive than the farther-term futures, which implies that the market expects volatility to decrease in the future.
The shape of the VIX futures curve has a direct impact on the value of VXX. To maintain a constant exposure to 30-day volatility, VXX has to roll its holdings every day by selling some of the near-term futures and buying some of the next-term futures. This means that if the curve is in contango, VXX will incur a negative roll yield every day, as it sells low and buys high. Conversely, if the curve is in backwardation, VXX will benefit from a positive roll yield every day, as it sells high and buys low.
Therefore, when buying puts on VXX, you want to see a steep contango in the VIX futures curve, as this will erode the value of VXX over time and make your puts more valuable. Conversely, you want to avoid buying puts on VXX when the curve is in backwardation, as this will boost the value of VXX over time and make your puts less valuable.
The Daily Roll Yield
The daily roll yield is the percentage change in the value of VXX due to the daily rolling of its holdings. It can be calculated as follows:
where VXXt is the value of VXX at time t, VIXt is the value of spot VIX at time t, and VIXt-1 is the value of spot VIX at time t-1.
The daily roll yield measures how much VXX deviates from spot VIX due to its rolling mechanism. A positive daily roll yield means that VXX outperforms spot VIX, while a negative daily roll yield means that VXX underperforms spot VIX.
When buying puts on VXX, you want to see a negative daily roll yield, as this will lower the value of VXX and increase the value of your puts. Conversely, you want to avoid buying puts on VXX when there is a positive daily roll yield, as this will raise the value of VXX and decrease the value of your puts.
The Implied Volatility of VXX Options
The implied volatility (IV) of an option is the expected volatility of the underlying asset implied by its market price.