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Why Volatility ETN ‘VXX’ Is Bad Insurance

Dave Nadig

At this week’s Inside Indexing conference in Boston, I had a conversation with a fairly savvy investor who I’ll decline to name. He’d seemed to have a lot of success this year so far, but was nervous about the market. “Are you making the long-Treasurys bet?” I asked. “Nope, I’ve been hedging with 10 percent VXX,” he replied, referring to the iPath S'P 500 VIX Short-Term Futures ETN (VXX).

I had to restrain myself from visibly cringing.

As I write this at lunchtime on June 20, the SPDR S'P 500 ETF (SPY) is trading around $161.05, off earlier lows.

When I was talking to this gentleman on the afternoon of June 18, it was at roughly $165, or about 3 percent higher. That’s the kind of gut-wrenching turn in the market that VXX is supposed to protect you from.

So let’s see what’s actually happened, and how that “hedge” might have worked. Imagine he had a $1 million SPY position, and decided to put an additional $100,000 to work, or 10 percent, as a hedge using VXX. Let’s say he put that VXX hedge on right as the market was hitting its recent high of $165.5.

Here’s how he would have fared:

Afternoon of June 18 position:

6,060 shares of SPY at $165:             $   999,900
4,939 shares of VXX at $20.25:        $   100,015
Total:                                                     $1,099,915

Right now, his position, after this big hiccup, would look like this:

6,060 shares of SPY at $161.05:        $   975,963
4,939 shares of VXX at $  21.26:       $   105,003
Total:                                                     $1,080,966

So what did this additional $100,000 at risk, perfectly timed, net him? He gained $5,000 in his VXX position to offset a $24,000 loss in his SPY position. That’s honestly not too shabby. It is, after all, $5,000 he wouldn’t have otherwise had.

But how else could he have ensured this position?

At the same time I was talking to him, puts on SPY that expire in August at $160—out of the money, but not dramatically—were selling for about $2.35. Right now, those same puts are trading for about $4.08. To get that same $5,000 in hedging return, he would have had to only buy 2,890 options, for roughly $6,700. That’s a lot less money at risk for a similar kind of insurance.

To fully hedge the position in a traditional sense, he could take out 61 contracts (covering 6,100 shares). In that case, he’d be out $14,335 in options premium. This afternoon, that position would be worth $24,888, for a gain of roughly $10,000.

At a somewhat ridiculous extreme, if he could also have put the full $100,000 he used in VXX to work in those puts, here’s he would have made out:



Afternoon of June 18 position:

6,060 shares of SPY at $165:               $   999,900
42,500 August 160 Puts at $2.35:       $     99,875
Total:                                                      $1,099,775

Right now, his position, after this big hiccup, would look like this:

6,060 shares of SPY at $161.05:           $   975,963
42,500 August 160 Puts at $4.08:       $   173,400
Total:                                                       $1,138,090

In this case, not only has he completely overcome the price drop in SPY, he’s actually made an additional $40,000 for “overhedging” his position.

I’m not suggesting this is a strategy the average investor should be pursuing—over-hedging your long equity exposure is, in a nutshell, a very speculative short play.

My point is simply this:If you’re holding on to a big long position and are looking for “insurance” because you’re nervous about recent highs, the markets developed a product for you a long, long time before the ETN was invented—the options contract.

Critics might point out that VXX is a position one can hold indefinitely, whereas using the options markets requires constantly re-establishing positions.

My counter would be:We all know how well long-term buy-and-hold positions of VXX works out for investors.


VXX vs. VIX Index


In fact, the CBOE Volatility Index, or VIX, simply uses the options market to create a complex version of the volatility assumptions already embedded in the puts and calls on SPY.

And then the futures market bets on that overly complex number, and then Barclays rolls that into a debt instrument called VXX you can bet on, with a negative expected return, thanks to the beauty of contango in the futures markets.

And people call options complicated?

Of course, there’s a much simpler way to handle that lingering suspicion that an asset you own may be headed for a retreat—own less of it in favor of another asset.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at dnadig@indexuniverse.com.


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