What is VXX and How Can You Trade It?

What is the VXX?

VXX is an exchange-traded note (ETN) that utilizes a portfolio of near-term S&P 500 VIX futures contracts to offer exposure to changes in implied volatility. VXX notes can be bought or sold, just like shares of stock, and VXX offers an options market as well. VXX was introduced in January 2009 as an alternative trading instrument to gain exposure to changes in S&P 500 implied volatility through a basket of near-term VIX futures contracts. Unlike an exchange-traded fund (ETF) that typically owns the underlying assets it offers exposure to, an exchange-traded note (ETN) is more like a bond instrument that tracks the performance of the asset without owning it.

VXX is typically used for hedging and speculation, rather than a buy-and-hold asset. This is because VXX exposes traders to changes in implied volatility by carrying a blend of near-term VIX futures contracts that must be rebalanced consistently. When VIX futures are in a normal curve, near-term contracts are less expensive than long-term contracts. This means that as a fund, the portfolio can underperform and drag down the price of VXX since selling less expensive contracts and buying more expensive contracts with a finite amount of capital will yield lower exposure over time.

How Does the VXX Work?

VXX seeks to offer near-term, equity market implied volatility exposure to traders and investors. VXX works by carrying a blend of the first and second month VIX futures contracts, and this portfolio is rebalanced daily. Because of this daily rebalancing and implied drag on the price of VXX when volatility futures are in a normal or contango curve, VXX is typically used for hedging and speculation rather than a buy-and-hold asset.

When VIX futures are in contango, near-term contracts are less expensive than long-term contracts. This means that as a fund, the portfolio can underperform and drag down the price of VXX since selling less expensive contracts and buying more expensive contracts with a finite amount of capital will yield lower exposure over time.

When you look at a price chart of VXX over prolonged periods of time, you might think the stock has fallen from extreme levels that it will never see again. In a sense that is true, as this product is truly structured to go to $0 when volatility futures are in contango. The graphic above shows a split-adjusted price of over the past ten years, which shows you the impact that the contango futures curve drag can have on this product. VXX has reverse split eight times since inception, and we should expect that to continue as S&P 500 volatility futures are normally in contango.

According to the prospectus, a reverse split in VXX will be in the ratio of 1:4. This means that if VXX notes are trading at $10, and a trader owns 4 of them, the post-split effect would be one note at a price of $40. Synthetically boosting the price of VXX while slashing note exposure to the same degree is how VXX can continue to exist when the volatility futures curve is in contango.

VXX vs. VIX: What Are the Differences?

While the VIX and VXX are both volatility products, they behave very differently in real-time and over extended periods of time. Learn about the differences and similarities below:

How is the VXX Calculated?

The price of VXX is calculated by taking the total market capitalization of the fund and dividing that figure by the total outstanding ETNs. For example, if the VXX market cap is $1,000,000, and there are 20,000 outstanding ETNs, the price of VXX would be $50 per note. The price of VXX changes based on a blend of movement in the first month and second-month S&P 500 VIX futures contracts. The percentage of exposure between each contract can shift and is not an exact 50/50 split.

As time passes, the performance of VXX is tied to how steep the forward curve is in the volatility futures markets. The steeper the contango curve, the more VXX is subject to dragging down in price over time. If volatility futures are in backwardation, which occurs when near-term futures contracts are more expensive than the next month, VXX can drift higher and realize substantial volatility. Looking back at the most volatile times over the past few years when markets were in backwardation, you can see a spike in the price of VXX. Conversely, when markets are calm and volatility futures are in contango, VXX drags down closer to $0 over time.

How to Trade the VXX

To trade VXX, you need to open a brokerage account. Since VXX is a trading product that feels like an equity, you do not need futures or options permissions to trade it unless you plan on trading VXX options.

1. Open a tastytrade brokerage account to start trading VXX notes or VXX options.
2. Develop a trading plan and understand the risks of trading VXX notes and VXX options.
3. Create a trade management plan for exiting winning and losing VXX positions.
4. Monitor your portfolio with the tastytrade web, desktop, or mobile platforms.

Why Trade the VXX?

Market participants trade VXX to speculate on upside or downside movements in the price of VXX. They also utilize VXX to hedge against adverse portfolio movements. For example, if a trader has a bullish portfolio, a bullish trade in VXX could hedge a quick downside move in equity markets.

As stated earlier, buying and holding VXX is not a suitable strategy when VIX futures are in a normal state of contango. When this normal market environment sustains, the price of VXX is structured to go down over time. That is why VXX has gone through eight reverse splits since inception to keep the product afloat.

For this reason and many others, it is imperative to understand the products you are trading and develop a risk management plan before placing trades in unique products like VXX.

VXX for Hedging

When traders look to VXX for hedging purposes, they may have a bullish equity portfolio. When equity markets take a nosedive quickly, volatility products like VXX tend to rise. This is especially true when VIX futures markets shift from a contango curve to backwardation. Increases in VXX do not last extraordinarily long, so those that use VXX to hedge a bullish portfolio may need to be more in tune with the markets than a passive long-term investor.

Still, using VXX bullish positions to hedge a bullish equity portfolio is difficult to time, since VXX drags down over time when markets are calm.

A bearish position in VXX may help hedge a bearish portfolio, as VXX typically drags down when equity markets are drifting higher. VXX can increase in price rapidly though, so position sizing and risk management is especially important when trading volatility products like VXX.