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Why isn't VXX tracking the VIX Index?

For those who have traded VIX-based volatility products such as VXX or VIXY, you may notice this. They do not seem to track the VIX index. On certain days, their movements can deviate a fair bit to the extent they can move even in opposite directions. This is unlike products such as SPY which tracks the S&P 500 index much more tightly. To understand why this is the case, we need to know a few things.


VIX Index is not your usual index. It cannot be replicated directly.


For a fund to replicate a stock index such as S&P 500, it is relatively straightforward. All you need to do is to buy into the shares of the companies comprising the index in the same proportions. While there will still be some tracking error, the day-to-day movements of the fund’s NAV and the S&P 500 will be fairly close to each other.


VIX, however, is not your run-of-the-mill index. The underlying composition of VIX is not some tradable securities. VIX is the implied 30-day volatility of the US stock market. It is a mathematical measure that is backed out from a basket of S&P 500 options. Because implied volatility is one of the components used to price options in the market. In short, there is no clean and easy way to replicate the VIX index.


What VXX tracks is not VIX but the VIX Short Term Futures Index.


As a result, what VXX actually tracks is not the movement of the VIX Index but the VIX Short Term Futures Index. Why? Because you cannot trade the VIX index but you can trade the VIX futures.


This index is like a synthetic VIX future that always expires in 30 days. To create such an index, we construct a basket of futures using the front and second-month VIX futures contracts and adjust them to the right proportions daily. That means they have to keep rolling a small fraction of the front-month into the second-month futures every day.


Let’s use an example to illustrate what I mean.

VIX Short Term Futures Index Movement Calculation
VIX Short Term Futures Index Movement Calculation

On Day 1, the front-month futures expire in 20 days, and the second-month futures in 48 days. This means the basket needs to contain 64% of front-month futures and 36% of the second-month futures. This keeps the expiry of the basket at 30 days and its price works out to be $25.02. You can work it out by just taking the weighted average of the future’s expiries and prices.


On Day 2, the same front month future will expire in 19 days and the second month future in 47 days. Based on that, we need to make an adjustment to the basket. We reduce the proportion of the front-month future to 61% and increase that of the second-month future to 39%. That, again, keeps the expiry of the basket constant at 30 days. Meanwhile, we value the basket using the new composition and the prices of the underlying futures. And that comes up to $25.70.


So, the percentage move of this synthetic future from Day 1 to Day 2 is 2.7% ($25.02 to $25.70). Theoretically speaking, if we disregard transaction costs, fees, and other expenses, this would be what we expect VXX to move.


VXX movements depend on the VIX futures term structure


VIX Term Structure (24 March 2022)
VIX Term Structure (24 March 2022)

Most of the time VIX’s term structure is in contango. That means longer-dated futures are priced higher than near-term futures and the near-term futures higher than the spot VIX index. And as time passes, if all other conditions remain unchanged including spot VIX, these futures will lose value and converge lower towards the spot VIX index. Thus, when the term structure is in contango, VXX will decay in value over time. And the reverse happens if the term structure is in backwardation. This is the case where futures are priced higher than the VIX index further out into the future.


VXX is affected by market demand and supply forces


VXX is an ETN listed on the exchange. So, it is also subject to the daily forces of demand and supply. At any one time, it can trade at a premium (above) or discount (below) its indicative value. And some events are capable of amplifying this deviation. For example, the most recent event where Barclays stop issuing new shares of VXX.


Then why use VXX to get exposure to VIX?


The reason is simple. Because there isn’t much alternative out there for retail traders who want pure exposure to volatility. And despite all the technical differences, VXX still holds a pretty high correlation with VIX of about 0.89 from the period Nov 2011 to Mar 2022. And out of all the trading days observed, VXX and VIX moved in sync with each other 84% of the time direction-wise. With the right strategy and understanding, VXX is still a highly tradable and valuable instrument to complement your portfolio.

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