The Ipath S&P 500 Vix Short-Term Futures Exchange-Traded Note (symbol: VXX) is probably the most unique and complex product to come along in years.

In short, it is an ETN issued by Barclay’s Bank PLC that is designed to track short-term volatility. VXX does this by tracking the volatility implied by close-to-the-money options on the S&P 500 composite index in ways similar to the Chicago Board of Exchange’s volatility index (symbol: VIX).

On the surface, you would expect VXX to track VIX. But, while VXX moves in the same direction as VIX, the degree of the respective moves can be quite different. The reason is that a number of factors go into the pricing mechanism of VXX that do not impact VIX.

VIX is a “spot index” whose value is based on the volatility being implied by current prices of close-to-the-money S&P 500 options. VXX, on the other hand, tracks a package of VIX futures contracts — specifically, the front two months. Thus, VXX is subjected to a “roll effect,” which can be a negative if VIX futures are in “contango” or a positive if VIX futures are in “backwardation.”

“Contango” is the term used to describe an upward-sloping forward curve that looks much like a normal yield curve. Simply stated, contango defines a market in which the longer futures are trading at a premium to the shorter-term futures or the spot market. “Backwardation” is the opposite of contango, in that longer-term futures contracts are trading at lower values than the near-term contracts.

Normally, a longer-term futures contract is worth more than a shorter-term futures contract because the former reflects the cost of carrying the underlying security for a longer period of time. However, because there are no costs associated with volatility, VIX futures are driven by sentiment rather than a “cost of carry” model.

Barclays traders roll over the package of VIX futures tracked by VXX on a daily basis. If VIX futures are trading in contango, the roll will generate a daily loss. If VIX futures are trading in backwardation, the roll can produce a profit — minus, of course, the costs associated with the rolling.

Daily rebalancing can impact the value of VXX by US2¢-US3¢ a share — again, positively or negatively. Some traders believe that because VIX futures gyrate between contango and backwardation, the impact will be minimal. Only time will tell.
@page_break@From a daily pricing standpoint, the use of two front-month volatility futures will impact VXX in terms of its percentage movement relative to VIX. Generally, if you invest in VXX, you should expect to earn about 35%-50% of the change in VIX spot price. This reflects a view that volatility spikes are temporary and do not normally remain in place 30 or 60 days into the future.

On the other hand, when VIX is declining, as it was in early August, traders don’t typically expect that to continue well into the future, effectively causing longer-term VIX futures to trade at higher prices (i.e., contango) than short-term futures — and creating a negative roll affect.

Now, to the next step in complexity. In May, the CBOE listed options on VXX, adding yet another dimension to trading strategies and complexity. With VXX options, you can implement covered call writes on volatility or simply go long in calls or puts on volatility.

More interesting is the fact that volatility itself is quite volatile — as you would expect from any security driven by sentiment. From an options trader’s point of view, VXX options are quite expensive, theoretically offering covered call writers an opportunity to generate some decent returns.

But that assumes that the options are correctly valuing the volatility inherent in a sentiment-driven security. Here’s where we get into greater complexity: volatility is subject to frequent, unpredictable movements — often referred to as “black swans” — that cannot be priced into any mathematical formula whose components are based on statistical models.

If traders buy into that theory, then perhaps the strategy of choice is to buy VXX options rather than selling them — specifically, buying short-term straddles on VXX. (A straddle is a strategy in which you buy close-to-the-money calls and puts with the same strike price.)

For example, VXX was trading at US$21.50 in early August. You could have bought the VXX August 22 calls and VXX August 22 puts (approximately three weeks to expiry) at a cost of US$2.50.

The potential or risk of a straddle does not hinge on your ability to predict the direction of volatility. If VXX rises, the call profits and the put loses. The reverse is true if VXX falls. Rather, the success or failure of holding a straddle depends on VXX breeching the trading range being implied by the straddle.

In our example, the three-week implied trading range for VXX is between US$19.50 (US$22 strike price minus a US$2.50 premium) and US$24.50 (US$22 strike plus a US$2.50 premium). Any breach of that range — either up or down — would generate a profit on this position.

If the black swan theory applies to volatility, you would expect the VXX August straddle to be profitable at some point prior to expiration. But this is a trade with a short-term focus — meaning that you should sell (i.e., close out) the call or put if its price exceeds US$2.50 a share. And then, depending on the value of the losing side of the straddle, sell it immediately or hold in expectation of a retrenchment in volatility. IE