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Friday, June 18, 2010

When ETN's Attack: VXX

A lot of growing chatter around the VXX ETN (exchange traded note) to play volatility, but heed this warning.

First, what is it? Per Yahoo Finance:

The investment seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract.
As VIX and More has detailed on multiple occasions:
VXX may be even less effective as a long-term holding. As previously discussed in VXX Calculations, VIX Futures and Time Decay, VXX suffers from negative roll yield when the VIX is in contango (when the front month VIX futures are less expensive than the second month futures), with the result that VXX loses a few cents each day due to rebalancing, just like a tire with a slow leak.

The current contango in the VIX is striking. This morning, when the spot VIX was 24, the one month forward contract was almost 27. If you buy this one month out contract (i.e. what the ETN does) and nothing changes in one month, the contract loses more than 10% (24/27-1 = 11%) of its value.

As long as contango remains steep, you better be damn sure volatility is going higher if you do anything, but short this security.

Source: Bloomberg