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  • Writer's picturePatrick Ling

The S&P 500 was flat, but VXX was down 2.4%. What happened?

The S&P 500 and the long volatility ETF VXX are generally inversely correlated. When the S&P 500 is up, VXX is down, and vice versa. However, there are instances when the relationship doesn't seem to hold. Yesterday was one such instance. The S&P 500 was flat, but VXX was down a significant 2.4%. This often leaves retail investors wondering if the VXX is broken. It can be hard to understand the price movements of VXX and other volatility ETFs because the underlying securities are VIX futures and not the S&P 500.

However, once you understand some basic futures terminology and what VXX is replicating, you will see that VXX and other volatility ETFs work as designed. It might seem daunting, but I'll try and break it down simply in this post.

What are futures?

A futures contract is an obligation to buy or sell a security at a fixed price on a fixed date in the future. For example, a corn farmer might want to lock in a price to sell his corn come harvest time in three months. He then sells the right amount of corn futures contracts that expire in three months. At expiry, he will sell his corn to the futures contract buyer at the fixed contractual price.

A simple futures contract between seller and buyer
A simple futures contract between seller and buyer

Let's say the buyer isn't willing to lock in the current corn price. The farmer has to look for someone else to enter into a futures contract with him. Let's say he is lucky, and a speculator happens to want to bet on corn prices rising. Everyone can still get what they need as follows.

Farmer enters futures contract with speculator instead of buyer
The farmer enters a futures contract with a speculator instead of the buyer.

In this second case, the futures contract would be a non-deliverable contract. There is no need to deliver any corn to the speculator on the expiry date. If the corn price exceeds the contractual price, the farmer pays the difference to the speculator. If it is below the contractual price, the speculator pays the farmer instead. In this way, the farmer receives the prevailing market price from the buyer, and any difference with the locked-in price is settled with the speculator.

We can replace the farmer with another speculator, and the trade is also valid. One speculator is betting for the price to go down, while the other is betting for it to go up. Some might see this as a non-productive activity, but it adds liquidity to the market. It will be much easier for the farmer or the buyer to find willing parties to take the other side of the trade. This will reduce the trading cost and improve market efficiency. This will lead to better price discovery as well.

Futures Term Structure

We used three months as the expiry date in the corn example above, but it doesn't have to be three months. A contract can settle in one month, six months, twelve months, or any other duration. However, the expiry is fixed upfront. It cannot change during the life of the contract. Do you expect the prices of the various expiries to be the same? Intuitively, we should know that the prices should not be the same, except by pure chance. We also do not expect Apple's share price to be the same at different times in the future. The term structure is simply the prices of the various contracts plotted against their respective expiry dates on the horizontal axis.

What does VXX track?

We know that VXX is a good hedge against an equity market sell-off, but do we know what exactly it tracks? It simply tracks the performance of holding a VIX futures contract with a constant one-month expiry date. The constant one-month expiry is tricky because the futures contract in the market comes with a few set expiry dates. As the day passes, the duration left on the contracts reduces. There is no single contract that has a constant one-month expiry. The VIX term structure below illustrates this.

VIX term structure
The one-month contract lies somewhere between the 1st and 2nd-month contracts.

The blue arrows point to two tradable VIX futures contracts near the one-month expiration mark. The green arrow points to the exact one-month contract, which is non-existent. We need to synthetically create this one-month contract by holding the two adjacent contracts in the right proportion so that the weighted maturity of the basket is one month. Below is an example of the makeup of the one-month basket on two consecutive days.

VXX basket allocation

Notice how there are more 2nd-month contracts and less 1st-month contracts on 6 Feb compared to 5 Feb. This is because as the day passes, the contracts get closer to expiry, and we need more of the 2nd-month contract to achieve the weighted 30-days to expiry. The issuers of the volatility ETFs would need to sell some of the 1st-month contracts and buy the 2nd-month contracts as time passes. The diagram below shows an example across 5th and 6th Feb.

VXX basket allocation mechanism
Change in basket allocation as each day passes.

Now that we know the mechanism behind VXX, we can see that VXX is tracking the performance of this constant one-month maturity basket. What determines the performance is the makeup of the basket and the change in prices of the two traded futures contracts. Below are the prices of the two contracts over the two days.

Change in VIX term structure from 5th to 6th February
Change in VIX term structure from 5th to 6th February.

We have everything we need to work out the basket's performance yesterday. All we need is to plug in the prices of the two contracts over the two days and work out the basket's weighted price on both days. The performance of the basket can then be calculated as shown below.

VXX basket performance

There you have it. The basket dropped 2.35% yesterday. This is just based on the price movement of the underlying VIX futures. Including the expense ratio of VXX, it should be close to the 2.4% drop we saw yesterday. Therefore, we should not be surprised by the move.

Useful diversified return stream

As we can see from yesterday's move, volatility ETFs can provide another source of return independent of the S&P 500. This is useful and why we include it as one of the asset classes in our multi-strategy portfolio. It is also powering our high-return strategy used in our capital-protected portfolio. Our advanced volatility trading strategy made money in 2022 while the S&P 500 went down double-digit. It also outperformed the S&P 500 in 2023. The longer-term model performance is shown below.

advanced volatility trading model performance
Long-term advanced volatility trading model performance

Note*: All performance data for the advanced volatility trading model used in this exercise are model performance. Live performance may vary due to execution price slippages, the difference in sizing precisions, etc. Past performance, whether backtested, modeled, or live is not necessarily indicative nor a guarantee of future performance.


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