Setting Up For VIX Spike With VXX Options

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options. Almost 128 million options on ETFs were traded in June, and because ETFs and options are among the fastest-growing financial vehicles in the world, it only makes sense to combine the two. This column highlights unusually large or interesting ETF options trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations examines the underlying options strategy.

The iPath S&P 500 VIX Short-Term Futures ETN (VXX | B-62) is notorious. It’s a debt instrument that trades like a stock and erodes in value like an option. It’s also one of the most active exchange-traded notes (ETNs) in the world. And one institutional trader thinks it’s going to rally more than 25 percent in the next two months.

The ETN’s long-term performance has been terrible, because VXX expresses its mandate with futures on the CBOE Volatility Index (VIX), the market’s leading measure of volatility. VIX futures are usually substantially more expensive than the cash VIX index that so many people follow. This “basis” is caused by the fact that VIX, unlike a basket of stocks, can’t be replicated.

This means that not only are the VIX futures that VXX holds more expensive than the VIX index, longer-dated futures are more expensive than shorter-dated futures because VIX futures decay gradually each day to converge on the lower VIX value on the day the futures expire.

Since VXX is constantly long these more expensive futures and is selling nearer-dated and cheaper futures each day, and buying longer-dated and more expensive futures, it will naturally evaporate over time, as you can see from the chart below:

While VXX obviously presents challenges, it was never intended to be a long-term holding. It’s a trading instrument that might be bought as a short-term hedge against an equity portfolio. Even then, it’s a pretty blunt instrument when sharper tools would generate a better result. That said, users of VXX continue to use it.

The Options Trade Setup

One institutional user of VXX wants to participate if VXX rallies significantly but is worried about VXX’s tendency to melt away over time. So he bought call options on VXX. The call options will melt away as the value of the options decay over time. That said, our institutional trader has defined his risk to the price paid for the options, unlike VXX, which might decline in value as it melts away and if VXX were to fall in value as expectations for stock-market volatility fall.

So, on Tuesday, our trader bought 10,000 of the $25 strike calls in VXX, expiring in August. The options cost $1.20 per share. Because each option corresponds to 100 shares, our trader now has the right to buy 1 million shares of VXX at $25.00 per share any time before his options expire at the close of trading on Aug. 21.

He paid a total of $1.2 million for that right and, because he bought the options, that premium paid—$1.2 million—is his maximum potential loss.

Examining The Payoff

You can see the simple payoff profile for this trade. All call purchases on ETFs share this general shape. Since our trader paid $1.20 per share, his breakeven point is $26.20. VXX has to be above that level at expiration to generate a profit. But below $26.20, the trade will result in a loss. And below $25.00, the loss will be the entire $1.20 spent.

Tough Row To Hoe

In buying a call on VXX rather than simply buying the ETN, our trader has defined the risk of the trade but made things pretty difficult for himself otherwise; he’s now long an eroding call option on an eroding ETN.

That’s not the only way this trade is like running uphill. VXX options are inordinately expensive. This August $25 strike call option trade implies an annualized volatility for VXX of more than 92 percent. That’s about eight times more expensive than a similar call option on the SPDR S&P 500 ETF (SPY).

Traders like VXX: Its average daily volume is more than 44 million shares for the last three months. That means it’s a trading vehicle rather than a long-term holding. We’ll see how our VXX call buyer makes out.

At the time of writing, the author didn’t own a position in VXX, and had a delta-neutral volatility position in various S&P 500 instruments. Also, the author’s firm, NationsShares, has created and licensed an alternative to the VIX. Follow Scott on Twitter @ScottNations.