Pricing VXX Options with Risk-Neutral Inputs

Summary

The document addresses how to price options on VXX, an exchange-traded product linked to short-term VIX futures, whose value can decline during contango. The question asks whether that negative expected drift calls for a change to Black–Scholes when rates are near zero. The answer says the no-arbitrage framework remains the same as for an individual stock: use the risk-free rate in option pricing rather than substituting the product’s observed historical decay as its drift.

Using expected contango decay as a pricing input instead amounts to taking a directional position on the futures curve. That view carries reversal risk: a negative market surprise may move the curve into backwardation, and returns can have heavy tails despite an attractive-looking Sharpe ratio. The response is brief and provides no formula, calibration procedure, or quantitative evidence. Its central distinction is between risk-neutral option valuation and a strategy based on expected realized drift.

Key ideas

• VXX options use the same no-arbitrage pricing framework as options on individual equities.
• The risk-free rate, rather than observed contango decay, belongs in risk-neutral option pricing.
• Treating expected decay as a pricing input embeds a directional view on the VIX futures curve.
• Curve reversals can create substantial tail risk even when a strategy’s Sharpe ratio appears attractive.

Tags

# How to price VXX options


# How to price VXX options












VXX is an etf that tracks 30-day constant maturity vix futures. Despite the popularity of the ETF and lots of Google searches I could not find any info on how options on this would be priced. I know it decays about 10% a month due to contango of the first 2 months volatility. So how would the no arbitrage condition work in the case of negative drift and 0% interest rates. Would this require a small tweak to the Black Scholes formula.

## Answer by Ezy (score 2)

https://quant.stackexchange.com/a/42192

no arbitrage works the same way for VXX options or IBM options. You use the risk free rate to price options.

if you price them using the observed drift (here decay due to contango), you are simply doing a "prop" type of strategy that accepts to hold the risk of curve reversal (on a negative surprise even the curve can get quickly into backwardation). The sharpe may look nice but your strategy will have fat tails in the distribution of its returns.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.