Why and How to Use VXX

This morning Adam Warner put up an excellent post on SchaeffersResearch.com about the risks of using iPath S&P 500 VIX Short-Term Futures ETN (VXX) as a hedge against increasing implied volatility. Adam sums up the misunderstanding many traders new to the product have about how (poorly, as a long-term hold) it has performed and what it really tracks:

VXX listed Jan. 30, 2009, at a split-adjusted price of $400 -- so yes, it really has lost 96% since then. The CBOE Market Volatility Index (VIX) has lost over half its value, so that explains part of it. The rest has to do with the fact that VXX proxies a constant 30-day VIX future that doesn't exist. To manufacture that future, the ETN providers must constantly roll out futures and swaps into a generally up-sloping futures curve (one word: contango). That constant roll for a loss costs money, which adds up over time -- and makes VXX act more like a simple put option than the volatility index it sounds like it's supposed to track. Like a put option, it can explode if you time it right... but also like a put option, it erodes over time, even if the market itself does nothing.

I agree, of course, that there's a problem with products like VXX, in the sense that some traders and investors start using it without understanding what it is. My only answer is to keep trying to educate my followers on Twitter (@volatilitytrade), Facebook, and this blog. And in that spirit, I'd like to add to Adam's cautionary post by pointing out that VXX (and VXZ, and other volatility-derived ETFs) can be very useful.

First, everyone should dedicate a small portion of their capital to tail-risk protection. (Tail risk refers to statistical anomalies--the one investors are most concerned with being crashes.) I don't believe in the "It'll come back" mantra investors use as a tool for denial and investment advisers exploit to take advantage of said investors. Eventually the market (or your IBM stock...but not, for example, Sun Microsystems) always bounces back, but wouldn't you be better off if you hadn't taken that 30% drawdown in the first place?

And that's where a little insurance comes in. Adam rightly likens VXX to a put option; it typically loses value over time. Like your homeowner's or car insurance premiums, you'll never get that money back--unless and until a catastrophe occurs...then it doesn't feel so much like all that money went down the drain.

This is why I allocate anywhere from about 2% to about 10%, depending on my assessment of current market risk, of my long stock portfolio to long-volatility ETFs. (I use a combination of SPY and IWM as a proxy for the market rather than picking individual stocks, but you can insure a stock portfolio by calculating the percentage based on the beta-weighted value of the stocks.) Part of that "insurance premium" goes into VXZ, which doesn't lose as much to contango as VXX, and part (the more risk, the higher the portion) goes into VXX, because it reacts more dramatically to short-term volatility spikes.

But, you say, if VXX (et cetera) is (are) like puts, why not just buy puts? Or VIX futures? I'm an options and (sometimes) futures trader, but I don't want to have to manage routine rolls when my SPX/SPY puts or my VIX futures are about to expire. I have bigger fish to fry with my options income portfolio, and products like VXX and VXZ let me not have to worry about my long stock portfolio except for an occasional rebalancing or an adjustment prompted by a change in my perception of market risk.

Viva VXX!