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Why Volatility ETN ‘VXX’ Is Bad Insurance

By
Dave Nadig
June 20, 2013
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With today’s crazy market volatility, surely holders of the market’s most popular VIX ETN were vindicated, right? Wrong.

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 (NYSEArca: VXX).

I had to restrain myself from visibly cringing.

As I write this at lunchtime on June 20, the SPDR S&P 500 ETF (NYSEArca: 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:

 

ETF DAILY DATA

Massive inflows into U.S. equity funds on Monday, Dec. 22, propelled total ETF assets to a new record.

'SPY' raked in more than $12 billion Monday, Dec. 22, pacing State Street's issuer-leading inflows on the day, as total U.S.-listed ETF assets jumped to $2.005 trillion.

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