Background on VXX
VXX is iPath's short-term VIX futures ETN, which maintains a constant one-month weighted average maturity by rolling one- and two-month VIX futures. Currently, the primary sources of return to VXX are as follows:
- VIX Index - VIX futures prices change in response to increases and decreases in the VIX index and future expectations of the VIX index level.
- Rolling costs - when two-month futures are greater than one-month futures there are negative rolling costs to VXX. When two-month futures are less than one-month futures the opposite is true.
- Convergence - depending on the level of contango / backwardation, returns can be generated as futures converge leading up to expiration.
Historical Context on VXX Returns and Implications for Option Valuation
VXX is a highly traded security and has options that trade at far out-of-the-money (OTM) strike prices. Given the high volatility of VXX, some of these far OTM strike prices are assigned higher values than I believe they are intrinsically worth.
I believe far OTM call options are properly valued because VIX futures have shown periods of extreme increases over short periods of time. For example, the VIX short-term index rose 196% over a 34 trading day period beginning 9/10/2008.
In contrast, the largest 34-trading-day VXX decline (since Q1 2008) was 23% beginning 12/20/2010, which also assumes that VIX futures began the period at the current level of one- and two-month VIX futures . Prior to Q1 2008, the trading range of one-month VIX futures was significantly different, ranging from 10.25 - 30.61 (pre-2008) vs. 15.55 - 67.95 (post-2008). Therefore, I will focus on post-2008 returns when analyzing max declines.
If you apply the max 34-trading-day decline of 23% to the current VXX price of $16.20, the resulting value is $12.47. Note, this max decline period assumes that VIX futures began at or below the closing values from last Friday 4/27/2012.
- One-month value = 18.05
- Two-month value = 20.15
Option Mispricing Observations
June 2012 VXX put options are exactly 34 trading days away from expiration. Although the max observed decline over this period leaves VXX at $12.47, I sold June 2012 put options last Friday for 6 cents each at an $11 strike price. Even if you look at pre-2008 declines, the largest 34-trading-day observed decline was 32%, which would leave VXX at $11.02 but still above the strike price at which I sold puts at.
Some might say that new max declines could occur over the next 34 trading days. However, when I repeated the largest observed 11-day decline three times and assumed the one- and two-month futures converged to the post-2008 low of 15.55 on option expiration date (an extreme and highly unlikely occurrence), VXX only fell to $10.73.
June expiration also provides the benefit that VIX futures expiration occurs after VXX option expiration. Therefore, VIX futures are even less likely to converge for June's option expiration.
Although many of you reading this may be short VXX, that doesn't mean you can't be short VXX put options as well. In addition to shorting these June 2012 $11 strike put options, I am short VXX and long IVOP. The strategy in this article is meant to capitalize on my belief that VXX may decline but will not decline further than $11 by June 15, 2012.
This raises an obvious question, why are market makers willing to buy these options from me. I believe this is due to their use of the Black-Scholes option pricing model. Black-Scholes assumes a normal distribution based on an input for implied volatility. Since implied volatility on VXX is high, the Black-Scholes model assigns values to far OTM options. However, the Black-Scholes model is not as accurate when the underlying has a mean-reverting level and well-defined historical ranges, as is the case with VXX. But mean-reverting assets are much easier to directly model as I have done in this article. However, market makers do not likely have enough time to perform the analysis I did to uncover this mispricing. So I believe mispricings like these can exist now and again in the future (as this is not the first time I have sold mispriced VXX put options).
Disclosure: I am short VXX. I am short VXX $11 strike June 2012 puts and am long IVOP.
Disclaimer: Please consult your financial advisor before making investment decisions. Depending on your circumstances and risk tolerance, the strategy in this article may not be suitable for all investors.