Extreme weather events such as wildfires, hurricanes, earthquakes, and tsunamis have been so frequent in recent years that many are asking (rightly so) whether the negative consequences of climate change may be finally materializing before our very eyes.

No matter your opinion on the climate change narrative, the countless people that have lost their lives, property, and/or livelihoods as a result of recent natural disasters are worthy of our thoughts and support.

Interestingly, the theme of “extremes” also arguably fits the narrative in financial markets through the last couples years. Consider, for example, the following data points.

Over the course of calendar year 2017, the average in the VIX was the lowest of any year in history, making 2017 possibly the Least Volatile Year Ever.

Then, in early 2018, volatility spiked in dramatic fashion, and the VIX staged its biggest-ever one day move in history (an increase of roughly 116%) in February, making it arguably the Most Volatile Day ever.

The balance of 2018 has seen the VIX exhibit behavior that’s been equally schizophrenic.

After the wild ride in January and February, spring and summer of 2018 were relatively tranquil, with the VIX falling back to the low teens for an extended period. However, the VIX broke out again in October/November, and has been trading consistently above its historical average of 19.

Aside from these dramatic moves, the VIX is also making news right now because another well-known volatility product, the VXX, is about to experience some changes.

The VXX is almost like a first-cousin to the VIX, and not just because it’s another widely followed gauge of market volatility. The VXX is basically a vehicle holding the VIX - although the details of its construction make things a little more complicated.

As a way of untying this volatility knot, consider first that the VXX is an Exchange-Traded Note (ETN). ETNs are designed to provide investors with a return similar to a market benchmark. In the case of the VXX, that benchmark is the VIX.

Based on the above, it’s easier to understand why the VIX and the VXX share a strong positive correlation. Now let’s look a little closer at the construction of each, which can help shed light on why the correlation is strong, but not perfect.

Recall that the VIX itself is not tradeable, and merely reports the level of short-term volatility that is implied by the value of options in the S&P 500. That’s why traders seeking exposure to the VIX typically utilize VIX futures and VIX options.

Going back to the VXX, we know that is is designed to replicate the return of the VIX.

The method by which the VXX attempts to replicate the VIX is by holding short-term VIX futures. The one complication with this approach is that futures expire, which means fund administrators of the VXX are routinely forced to sell front-month VIX futures in favor of buying second-month VIX futures.

While this may be the required strategy of the VXX as outlined in the prospectus, that doesn't necessarily mean it's optimal.

Looking back at historical data in VIX futures, tastytrade estimated that roughly 70% of the time, second-month VIX futures have traded at a premium to front-month VIX futures. This paradigm is known as contango, when longer-dated futures trade at higher prices than shorter-dated futures (the reverse is known as backwardation).

Ultimately, that means the VXX makes its living selling the lower valued VIX future (expiring front-month) in favor of purchasing the higher valued VIX future (second-month). In the investment universe this is called "drag," and one can see why the term fits - because over time this approach has dragged down the value of VXX.

The chart below, taken from a recent episode of Market Measures, illustrates how the VXX has performed since inception:

The Greatest Short of All Time

Another critical piece of information to understand about ETNs is that they eventually expire, which is exactly why VXX has been especially newsworthy of late.

The VXX is scheduled to expire at the end of January in 2019, and will be replaced with the VXXB. ETNs generally expire 20 to 30 years after inception, and 2019 just happens to be the predetermined point in time in which the VXX will cease trading.

For more information on the VXX and the new VXXB, we recommend reviewing the aforementioned episode of Market Measures when your schedule allows.

If you have any questions about trading the VIX, the VXX, or the VXXB, we hope you’ll leave a message in the space below, or reach out directly to @tastytrade on Twitter or send an email to support@tastytrade.com.

Additional information on these volatility products can also be found through the search functionality on the tastytrade website.

Thanks for reading!


Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.


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