How VXX Rolls VIX Futures and Why Contango Can Erode Value

# Rolling Futures - VXX


# Rolling Futures - VXX












I was reading this paper (https://www.cmegroup.com/education/files/deconstructing-futures-returns-the-role-of-roll-yield.pdf ) about futures rollover, and cannot figure out the meaning of the sentence in bold:

On a snowy New Year’s Day in 2012, an individual investor (we’ll call him Spencer) takes a seat by the fireplace and opens his brokerage statement. He is relatively happy with what he sees: US stocks, which make up the vast majority of his assets, have doubled since the lows of March 2009. However, economic and political risks such as the European debt crisis continue to cause concern, and he wants to protect his gains. Spencer’s friend Victor tells him about the VIX, an index of market volatility that tends to go up when the market goes down. Victor points out that while Spencer can’t trade the VIX directly, he can trade VXX, an exchange-traded note (ETN) that is linked to the VIX. The following day, Spencer buys enough VXX to put his mind at ease. He trusts that, if stocks fall, VXX will provide some protection. Besides, the VIX level seems low enough (23.4, after peaking above 80 during the 2008 financial crisis) that Spencer figures there’s not much downside. Six months later, Spencer sits by the pool and reviews his portfolio. He finds that his US stock investments have risen by about 6%. He notes that the VIX level is 19.6, a 16% drop. But he is surprised to find that his VXX investment is down 54%. Furthermore, he discovers that when the S&P 500 hit a rocky patch from mid-March to early-June (falling nearly 10%), VXX was essentially flat even though the VIX rose by 74%. Confused, Spencer searches the internet for “VXX." He reads that **VXX actually tracks not the VIX itself, but “a constant one-month rolling long position in first and second month VIX futures contracts.”**Further exploration leads Spencer to numerous references to “contango” and the dangers of “roll yield.” Realizing that he does not understand what these concepts mean and how they affect his returns, he decides to close out his VXX position.

What do they mean by one-month rolling long position in first and second month VIX futures ?

Thanks

## Answer by StackG (score 3)

https://quant.stackexchange.com/a/57146

Great question! To answer this, there are a few things we need to know about futures in general, and VIX in specific. I've skipped some details below to keep the length reasonable, feel free to ping in the comments.

- Futures are exchange-traded contracts that have a fixed expiry and reference an underlying security. At expiry, the hoder of a futures contract is either delivered one of those securities (physical settlement) or delivered the price of the security (cash settlement). Because the contract expires at this point, if you are holding a futures contract for long term exposure, you need to roll your contract before expiry, which means selling the close-to-expiry contract and buying a longer dated contract.

- VIX futures trade with expiries once a month, with an expiry date mid-month. The Front Month Contract is the closest contract to expiration, which will expire in less than a month. The Back Month Contract (or Second Month Contract) is the contract that expires in the following month. As with most futures, these two contracts are where almost all of the liquidity is concentrated.

- VIX futures are cash settled, and the price that you recieve at expiry is equal to the value of the VIX index. This is not a tradable security itself, it's calculated by the CBOE from options on S&P500 futures (it roughly reflects the cost of a 1-month variance swap, but that's a detail).

VXX is an ETN, which (barring some technical details) is fairly similar to an ETF - basically it trades like a share reflecting part ownership in a basket of assets. We can't trade the VIX index itself (as it's untradable) so it tries to track the price of VIX futures instead, and holds positions in the Front Month and Back Month contracts. But wait a second - these expire! It's not a very good business running a fund (and taking a management fee...) if everything inside the fund expires to cash in a couple of months which would have to get returned to investors. So instead, VXX carries a 'constant maturity basket' of Front Month and Back Month contracts.

What this means is that every day, it sells a little bit of Front Month, and buys a little bit of Back Month, so that by the time Front Month expires it's completely rotated into Back Month contracts. At this point, the Back Month becomes the Front Month contract, and the whole process continues.

Now, lets look at the current price of VIX futures today (Front Month and Back Month are circled, the peak in October is due to amrket expectations of extra volatility around the US presidential elections):

As we can see, today the market is in contango, which means the Back Month is worth more than the Front Month. Because the Front Month will settle to the cash level in a few weeks, it's also getting pulled down quite quickly towards the green dashed line. Consequently, every day the fund has to sell some of the cheaper-and-cheaper Front Month, and buy some of the more expensive Back Month, so its AUM is gradually getting drained away.

Why would anybody want this? Well, like VIX in general, there is an upside when implied volatility spikes during crashes. The cash level of the VIX index shoots up very fast, and suddenly the Front Month future is getting pulled upwards towards it, so VXX is now selling expensive Front Month and buying cheap Back Month - it's AUM increases during this sort of crisis - here is how the same graph looked back in March/April:

All in all though, VXX really isn't a long-term play. If you google 'VXX Stock Price', they will show you how holding the ETN for a period of time would look, and on the whole, it is not pretty!!

1Y holding period, up a bit - and works very well if you get the entry and exit right:

5Y holding period, disaster! VXX is NOT a long-term play on vol!