Understanding trading the VIX
Inverse S&P 500 VIX Short-Term Futures ETN (NYSE: XXV) is the inverse VIX.
Well, more specifically, its inverse iPath S&P 500 VIX Short Term Futures ETN (NYSE: VXX).
If you’re interested in trading XXV this link will provide you with the prospectus.
http://www.sec.gov/Archives/edgar/data/312070/000119312510160327/d424b2.htm
And here’s how they will determine the value:
On the initial valuation date, the inverse index performance amount for each ETN will equal $0.
On any subsequent calendar day, the inverse index performance amount for each ETN will equal the product of (a) negative one times (b) the principal amount per ETN times (c) the index performance percentage on such calendar day. ”
Like all other contrived ETNs and ETFs, this one has a tragic flaw that makes long-term holding a disaster. In this case, it’s compounding math.
For ease of example, let’s say VXX is $100, and XXV has just listed at $100, as well.
On day one, VXX rallies 10% to $110. XXV will do the inverse, and drop 10% to $90.
On day two, VXX rises another 10%, to $121. XXV drops 10%, or $9, in response, to $81.
Now, on Day three, VXX gives back the whole $21 gain, a drop of 17.35%, back to $100. Otherwise known as unchanged over the three trading days. So XXV rallies 17.35% from $81 all the way up to … $95.05.
Yes, that’s right, after three days VXX has made a net move of $0, yet you’re down 5% in XXV.
Damn you compounding math!
I used inordinately large moves just to illustrate the point, but it’s the same story any time you play with inverse and/or leveraged ETFs. They’re perfectly fine to trade, but use extreme caution holding them in a portfolio.
