Last updated on April 9th, 2022 , 06:43 am
In 2022, volatility products have been exploding in popularity. There are two catalysts behind this drive:
- 1. Retail traders are becoming more sophisticated.
- 2. Market volatility has increased investors’ desire to hedge their portfolios.
However, getting started with trading volatility can be a daunting process. There are numerous ETFs out there that track volatility, all in their own unique way.
Two of the most popular volatility products are the exchange-traded note (ETN) VXX (iPath® Series B S&P 500® VIX Short-Term Futures) and the VIX Index (CBOE Volatility Index).
The first thing to understand is that these two products have very different investment strategies; they should not be used interchangeably. While both track volatility indexes, there are some huge differences between them.
In this article, projectfinance will go over the main differences between these two products. Additionally, we’ll explain the benefits of volatility products as well as the similarities that both VIX and VXX share. Let’s get started with our comparison chart below!
VIX vs VXX
| VIX | VXX | |
|---|---|---|
|
Settlement Method |
Cash Settled |
Physical Delivery (Stock Settled) |
|
Style |
European |
American |
|
Underlying |
S&P 500 options |
VIX Short-Term Futures |
|
Profound Time Decay |
No |
Yes |
Let’s start off by looking at the definition of these two products, as well as their respective histories.
VIX Definition and History
VIX Definition: The “VIX”, also known as the “Fear Index”, is the ticker symbol for the Chicago Board Options Exchange’s CBOE Volatility Index. This index measures the market’s expectations for volatility over the proceeding 30 days based on near-term S&P 500 index options.
VIX does not offer stock, but it does offer futures and options trading.
VIX History: The VIX is the oldest and most popular volatility product. The VIX was conceived in 1990. Futures on the VIX began trading in 2004; options on the VIX were first offered in 2006.
VXX Definition and History
VXX Definition: The iPath® S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note offered by Barclays PLC. Unlike ETFs, ETNs are “fixed income” securities and therefore must track the performance of their representative index; there is no tracking error. However, it is a futures-based ETF, which carries significant risks.
This volatility “ETN” tracks the short-term futures of the VIX with 30 days to expiration. However, there is no futures contract on the VIX that is always 30 days to expiration; the dates constantly change. To remedy this, Barclays utilizes two futures contracts (front-month and the proceeding month), and constantly adjusts the respective position sizes so the net days-to-expiration is 30 days.
Unlike VIX, VXX does have underlying stock which you can trade.
VXX History: Barclays VXX first began trading in 2009. This particular “series” shut down in 2019. Later, another version of VXX was launched by Barclays, called VXX series B, which trades under the old ticker of VXX.
VXX vs VIX Fundamental Difference
Before we get started, let’s first examine the roots of our two products.
The key to understanding the difference between these two products lies in their composition: the VIX is formed with S&P 500 options; VXX is formed with VIX futures. Therefore, you can think of VXX as a sort of “derivative of a derivative”, not to get too “Inception” on you!
3 Reasons to Trade (or Monitor) Volatility
Before we get into the differences between VXX and VIX, it may be helpful to first understand the reasons behind their popularity. Unlike stocks, volatility does not appreciate in value over the years, nor do volatility products pay dividends. So why do investors trade volatility products?
1. Volatility as a Market Hedge
Volatility products were created as a way for traders to mitigate risk. How?
Let’s say that you own 100k worth of stock in the SPY ETF. You are a senior investor and worry that the unemployment number coming out tomorrow may have an adverse effect on your portfolio. However, (perhaps because of tax reasons) you don’t want to sell any of your stock. Instead, you could purchase an equivalent amount of call options in the VIX. That way, if the “fear index” skyrockets, the appreciation of your VIX calls will help offset any losses on your stock.
2. Trading Volatility (VXX and VIX) for Stock Market Speculation
Though volatility products offer investors a great way to hedge, most contracts traded in VXX and VIX (particularly VXX) are the result of traders speculating on market direction. Professional traders love to “sell volatility”. When volatility is sold, traders profit when the index (VIX) or ETN (VXX) either stays the same or goes down in value. This is typically what happens in normal markets, thereby it is a consistent way to generate income.
However (and a big however), this strategy certainly isn’t the only one; one trader nicknamed “50 cent” on the CBOE loved buying out-of-the-money calls on the VIX. He executed this strategy for one year, slowly accumulating painstaking losses.
And then, one week, following a steep market sell-off, 50 cent racked in a $200m profit!
Selling volatility usually makes money, but if you’re not hedged and the market goes south fast, watch out! 50 cent is waiting for you.
3. Volatility Index’s Provide Value for Everyone
You don’t have to trade volatility products in order to take advantage of their utility. The VIX index is a great indicator of market uncertainty. If you’re the owner of a portfolio of stocks and wish to get a window into the future predicated moves of the market, the VIX is a great tool. It is the most reliable index for stock market volatility in the world.
Similarities of VIX and VXX
Before we get into how VXX and VIX differ, let’s explore some of the similarities of the two. After all, VXX and VIX are more alike in nature than they are different. Here are three similarities:
- Both VXX and VIX rise in value during steep market declines.
- In the short-term, price movement tends to be relatively synchronized between the two (but not always!). Take a look at the graph below. (Later we will look at a 3-year graph comparing the two).
3. Implied Volatility (IV) on Volatility Products
The “IV” of traditional indexes and equities tend to go down with further out-of-the-money strike prices. Volatility products, however, act just the opposite: the implied volatility on VXX and VIX both rise with higher strike prices. Take a look at the below screenshots from the tastyworks platform comparing the IV on the VIX and SPX (which tracks the S&P 500).
5 Differences Between VIX and VXX
Let’s now explore the most important part of this article: the 5 difference’s between the two products!
1. VXX Price Decays Faster Than VIX
Though VXX and VIX have a lot in common, they are verily not the same products. We spoke earlier about the composition of the two products: VIX is composed of S&P 500 options; VXX is composed of futures contracts on the VIX. The result for VXX is a “synthetic” futures contract. This results in inefficiency.
Take a look at the below chart, which compares VXX to VIX over a duration of three years.
Over the course of 3 years, VIX rose 59% in value while VXX dropped over 70%. So why such a drastic difference in return?
Historically, VIX futures (which VXX comprise) are priced at a premium to the index, particularly futures that settle more than 30 days away (which VXX also encompasses). However, as expiration nears, that premium begins to decay. The resulting price action can result in futures on the VIX losing more in value than the respective index.
Though this price differential isn’t a lot over the short-term typically, the above graph shows us just how devastating it could be to investors long VXX over time.
2. VXX and VIX Are Made of Different Underlying's
The CBOE’s VIX index is constructed using the implied volatility on SPX options. These options are “front-month”, and represent the market’s expected move for the proceeding 30-days.
Barclays VXX ETN is based on VIX short-term futures. Since there is never a constant future contract with 30 days until expiration, VXX uses a combination of the two front-month VIX futures in order to synthetically mirror a perennially 30-day future contract.
3. VXX and VIX are Styled Differently
All options are either styled American or European.
European Style Options
VIX options are “European” style (Investopedia). This simply means that options traded on VIX do not allow for early assignment/exercise. However, this doesn’t mean you can’t exit a long position in VIX before expiration, you simply can’t exercise your contract before expiration.
This is an added benefit for trader’s short options in VIX; since early exercising is not allowed, you will never have to worry about being assigned before expiration!
American Style Options
VXX options are “American” Style (Investopedia). This means that the owner of a VXX option (call or put) has the right to exercise their option contract at any time (though this rarely happens when extrinsic value is on the table).
We mentioned earlier that VIX has no tradable stock. Therefore, what do you actually deliver if you choose to exercise your option or are assigned at expiration?
That brings us to our next difference:
4. VIX is Cash-Settled; VXX is Physical-Delivery
Most European-style options are cash-settled. Most American-style options require physical delivery upon settlement. This stays true for VIX and VXX.
Cash Settled Options Definition (VIX): A settlement method used in options trading that does not require delivery of the underlying shares. Instead, a simple transfer of cash takes place which corresponds to the closing intrinsic value of the options.
Therefore, VIX options are settled via an exchange of cash.
Physical Delivery Options Definition (VXX): A settlement method in options trading that does require delivery of the underlying shares is “physical delivery”. When options are assigned and exercised under this method, shares of stock (typically 100 shares per options contract) are exchanged.
Long/short call options under this method will buy/sell shares (respectively) of the stock at the strike price of the option. Long/short put positions will sell/buy shares of the stock at the strike price of the option.
Unlike VIX, Barclays VXX product does indeed offer stock. Underlying’s that offer stock are settled in stock. All option contracts in VXX are settled via physical delivery of the underlying ETN.
5. VXX Allows for the “Contango” and “Backwardation” Trade
Though VXX’s strategy to use two months of future contracts creates some inefficiency, it also offers traders some benefits, such as the “contango” and “backwardation” trade – CME.
Backwardation Definition: Backwardation occurs when the price of a futures contract is trading at a discount to the expected spot price at expiration.
Contango: Contango occurs when the price of a futures contract is trading at a premium to the expected stock price at expiration.
In times of market distress, such as during the early days of the pandemic, the short-term forecast for a market is more uncertain than the long-term forecast. This leads to backwardation.
Conversely, in a confident market, contango is often the resulting effect on future prices.
Traders in VXX can take advantage of these two market events by participating in “arbitrage”. This is a very complex process and requires much research.
Final Word
At first glance, VXX and VIX may seem to be very similar in nature. However, after putting the two products under the microscope, we can see there are some major differences between the two.
Retail traders love VXX. Let’s end by taking a look at a few of the advantages of VXX.
- 1. VXX options offer more strikes and expirations, allowing for more custom-tailored strategies.
- 2. The markets on VXX tend to be tighter than those of VIX, which allows for greater liquidity.
- 3. Volatility sellers prefer VXX because of its profound time decay.
