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VXX, VIX, and Hedging against Market Risk

|Includes:SPDR S&P 500 Trust ETF (SPY), VXX

If you own VXX Exchange Traded Note (NYSE:ETN) or are considering buying it, it's worth reading Eric Falkenstein's recent blog post on it "VXX Risk Premium?". Excerpt:

As Harvey and Erb (2007), or Gorton and Rouwenhorst (2005) have noted, the roll in futures is predictable: you tend to make money going long futures in backwardization, short futures in contango. Thus, the VXX has declined much more than the VIX since it started trading in January 2009 because it has been riding the roll down the futures curve all the time:

As that chart from Dr. Falkenstein's blog post shows, when the VIX index spiked early this year, the VXX ETN only rose a fraction as high. So VXX hasn't been an ideal vehicle to buy to bet on spikes in volatility as measured by the VIX. But why are investors betting on spikes in volatility in the first place? Presumably, many investors who own VXX assume that a severe market downturn will be accompanied by a spike in volatility, so betting on a spike in volatility is an indirect way for them to hedge their long-only equity portfolios against that market risk. If so, those investors might be better off hedging against market risk more directly by using Portfolio Armor to find the optimal puts to buy on an index ETF such as SPY.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: My company operates the investing app Portfolio Armor.
Stocks: SPY, VXX