An introduction to volatility, VIX, and VXX Pravit Chintawongvanich

• What is volatility? Head of Derivatives Strategy

• Is it possible to “buy” the VIX? pravit@macroriskadvisors.com
• VIX futures, options, and VXX (212) 287-2640

In this piece, we explain the basic concepts of volatility and introduce VIX futures, options,
and the VXX. We will approach these products from the standpoint of an investor who wants
long exposure to volatility, saving discussion of more advanced techniques (e.g. VIX
structures and strike selection, shorting volatility) for following pieces.

What is volatility?
Practitioners often speak of volatility in two ways: realized volatility and implied
volatility.

Realized volatility refers to how Low vs. High Realized Volatility

150
volatile something has been; it is
backward-looking. Here, we show two 140
Asset 1 Asset 2

price charts. Asset 1 has had a higher

“realized volatility.” 130

120
Practitioners generally measure stock
volatility by looking at daily percentage 110

moves over a certain time period, e.g.

“3-month realized volatility” refers to 100

the volatility of daily price changes over 90

the past 3 months. The number is
typically quoted on an annualized basis; 80

for example, a stock that moves 2% a Source: Macro Risk Advisors, Bloomberg
70
day on average could be said to have a
realized vol of around 32%.
Implied volatility refers to the market’s price of volatility; it is forward-looking. How do we
know the market price of volatility? We derive it from the option prices.

For example, consider call options on two $100 stocks that don’t pay dividends. If the two call
options are otherwise identical (e.g. strike, time to maturity, etc.) and the call option on stock
A is more expensive, then stock A can be said to have a higher implied vol.

Generally (but not always), the market charges a premium for implied volatility. In other
words, if a stock typically realizes 16 vol, the options might trade at 18 vol (a 2 vol premium).

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
1 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 The element of time
The key to understanding volatility (and options) is time. Unlike a stock, options are time-
limited contracts. An option with more time to expiry will always be more expensive than an
identical option with less time to expiry.

Imagine that the S&P is at 2,000 and we buy a call option struck at 2,500. We would pay more
money for the call option with one year to expiry than the call option with one month to
expiry, because it gives us more time to end above 2,500. Now let’s say the S&P 500 stays flat
at 2,000 until the option expires. Over time, the call option will “decay” and eventually expire
worthless.
Option Price (as a % of spot) vs. Time to Expiry
9%

8%

7%

6%
Option Price

5%

4%

3%

2%

1%
Source: Macro Risk Advisors
0%
1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
Time to Expiry

The concept of time decay is fundamental to understanding volatility trading. You never
“own” volatility, you just “rent” the exposure. Every bet on volatility has an implicit
time limit.

Volatility is not a financial asset

Volatility is not a claim on tangible assets like a company’s stock or a bond, and cannot be
owned directly. The only way to have P&L exposure to volatility is to trade derivatives:
either derivatives on an asset (e.g. options), or derivatives on volatility itself (e.g. volatility
futures and options).

Options can never be free

If options were free, we could make money risk-free. Because options can never be free (they
must always have some value, however likely they are to expire worthless), implied volatility
can never be zero. This gives us a lower bound for the VIX: we know it can never be zero. In
fact, since 1990, there have been only nine days when the VIX closed below 10.

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
2 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 The VIX
The VIX is a measure of 30-day implied volatility in S&P 500 options. Roughly speaking, it
looks at the cost of S&P puts and calls of every strike with 30 calendar days to expiry, and
turns this into one number. Importantly, one cannot “buy” the VIX, because it is just a
calculation. In reality, if we tried to replicate the VIX by buying the 1-month S&P options that
go into its calculation, we would be subject to time decay: the next day, we would own 29-day
options. Eventually, we would own 1-day options, and on expiry, most of our options would
expire worthless.

However, we can trade derivatives on the VIX: VIX futures, VIX options, and ETFs holding
VIX futures such as VXX.

VIX Futures
VIX futures are cash settled futures contracts on the VIX (which tracks the cost of one-month
S&P options). In normal times, futures trade at a premium to the spot price; in other words,
the curve is upward sloping or in contango.

The upward-sloping curve (pictured below) does not necessarily mean that investors think
volatility will be higher in the future. They trade at a premium to spot because 1) there is a
decay cost to owning volatility and 2) more time to expiry means more could
happen, and thus a higher volatility risk premium is charged. I like to think of this as
“renting” long volatility exposure. To understand why this decay cost exists, imagine if there
were no decay cost and the futures always traded flat to spot. Then you would always buy VIX
futures when VIX was very low (let’s say 9-12), because you know that the VIX cannot go to
zero, and make a riskless profit. For this reason, we generally see the steepest curves (highest
decay cost) when the VIX is low.
VIX Futures Curve
19.0

18.0

17.0

16.0

15.0

14.0

Source: Macro Risk Advisors, Bloomberg

13.0
Spot Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
3 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 VIX Spot vs. Oct '12 VIX Future
In the absence of any volatility events, 35

over time VIX futures tend to decline VIX Spot Oct '12 VIX Future

in price towards VIX spot, as 30

illustrated here. As such, selling VIX
futures is generally consistently
profitable (but with occasional large 25

drawdowns) and buying VIX futures is

generally a losing trade (with 20
occasional windfall gains).

15

Source: Macro Risk Advisors, Bloomberg

10
1/23/12 2/23/12 3/23/12 4/23/12 5/23/12 6/23/12 7/23/12 8/23/12 9/23/12

Likewise, when the VIX spikes, we can see a downward-sloping (or inverted) VIX curve
(pictured below). In this case, it reflects overwhelming demand for near-dated protection, or
that investors think the recent volatility will not last in the long term. Of course, shorting VIX
futures when the curve inverts is no guarantee of making money, as it can always get more
inverted.
VIX Futures Curve as of 8/8/2011
50

45

40

35

30

25

Source: Macro Risk Advisors, Bloomberg

20
Spot Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12

Generally speaking, near-dated futures are more reactive than long-dated futures, and will
track VIX spot most closely. A futures contract with only 1 day to expiry will come close to
tracking VIX spot.

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
4 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 VXX
VXX is an ETF that holds VIX futures. It holds first and second month VIX futures, rolling
them on a daily basis to keep a weighted one-month exposure. VXX will have a high
correlation to VIX spot, but not track it exactly – generally, its daily moves will be of a lower
magnitude than VIX spot. For example, on July 27th VIX spot was up 13.5%, while the VXX
was up 5.5%.

As we mentioned above, owning VIX futures has a decay cost. This becomes quite apparent if
you look at a long-term chart of the VXX (below). There is no limit to how low VXX can go,
because it represents a trading strategy rather than a financial asset. VXX has had three 1-for-
4 splits in its 6 year history and will have countless more in the future. We can estimate the
monthly “cost” to owning VXX from the steepness/flatness of the VIX futures curve. Generally
speaking, we can expect a “drag” of anywhere from 5-10% per month (independent of what
VIX futures do).
VXX (5 year chart) VXX (5 year chart, log scale)
2,000 2,048
Source: Macro Risk Advisors, Bloomberg Source: Macro Risk Advisors, Bloomberg
1,800
1,024
1,600
512
1,400

256
1,200

1,000 128

800
64
600
32
400

16
200

0 8
Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15

VXX vs. VIX, 2012-2013

Importantly, this drag means we can be 400 30

“right” about the ultimate direction of 350

VXX VIX

volatility, and still lose money. For example, 25

let’s say we buy VXX when the VIX is 12. 300

Several months pass, and the VIX goes to 20

20. Yet we find that we are only flat (or even 250

down) money on the VXX buy. The reason 200

15
comes back to time decay – to make
money buying volatility, you not only need 150

to be right about the direction and 10

100
magnitude, you also need to be right about
how quickly it happens. 50
Source: Macro Risk Advisors, Bloomberg
5
Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
5 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 This constant decay does not mean VXX is a “flawed product” as some claim. Simply put, it is
impossible to own optionality (or volatility) without paying decay, and the constant decline of
VXX reflects this.

Why doesn’t everyone just short VXX?

Given the headwinds to being long volatility – paying time decay and getting the direction
right – one might ask, “Why not just short VXX”? The answer is that people do, and selling
volatility (whether it be through directly shorting VXX, or selling volatility premium in other
ways) is a popular trade. Of course, being short volatility puts us at risk of unlimited,
unpredictable loss. Would you rather make steady money 95% of the time and lose big money
5% of the time, or the other way around? The answer lies in one’s risk tolerance, investment
mandate, and ability to withstand loss.
Constant $500k short VXX exposure
(starting with $1mm portfolio) Aggregate P/L of Selling One Month SPX Variance
3.0M 220M
Source: Macro Risk Advisors, Bloomberg
200M

2.5M 180M

160M
2.0M
140M

120M
1.5M
100M

80M
1.0M
60M
Aggregate P&L of selling 10k vega
of one month SPX Variance struck
0.5M 40M at the closing level VIX each day

20M
Source: Macro Risk Advisors, Bloomberg
0.0M 0M
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Mar-90 Feb-92 Feb-94 Feb-96 Feb-98 Feb-00 Feb-02 Feb-04 Feb-06 Feb-08 Mar-10 Feb-12 Mar-14

Long volatility through buying VXX

Buying VXX will give us a constant exposure to the reactive front end of the VIX futures curve.
However, as discussed above, we will be paying decay. As our VXX position decays away, we
will have less and less exposure to volatility. While this limits our loss to the amount of VXX
we bought originally, it also limits our exposure to long volatility over time. The volatility of
August 2011 was little consolation to somebody who bought VXX when it was first listed in
2009! In other words, to keep the same exposure to volatility, we need to constantly add to
our VXX position. This is exactly the same problem that buyers of option protection face: you
need to constantly renew the hedge.

A sensible way of thinking about our VXX exposure is 1) the maximum amount we
expect to lose in decay per month and 2) the maximum amount we expect to lose
due to implied volatility decreasing. These amounts may end up being far more than we
expect to make on an increase in volatility, especially if we don’t have a good idea of when this
happens.

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
6 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 For example, suppose the one-month VIX future is 15. We estimate the monthly VXX drag at
8% per month. We think the one-month VIX future can increase to 20 (a 33% increase). We
think the lowest the one-month VIX future can go is 13.5.

Suppose we spend $100k on VXX. In the “neutral” scenario where the one-month VIX future
is flat, we can expect to lose 8% over a month.

In the worst case scenario, the one-month VIX future decreases to 13.5 (a 10% decline) and
we pay the 8% decay, for a 17k loss (100 * 0.9 * 0.92 = ~83).

The gain in the best case scenario depends on the timing. If the one-month VIX future
instantly goes to 20, we make 33%. If it goes to 20 after 2 months’ wait, we first lose 15% in
decay, taking our exposure down to 85k (100 * .92 * .92), then we make 33% on the 85k
notional, taking the value of our position to 113k. We end up making only 13% on the original
investment.

Options on VIX and VXX

If we buy call options on VXX, we limit our potential loss, but due to the “drag”, over the long
term we will be slowly slipping away from our strike price. When the spike in volatility comes,
we may find that VXX is far below the strike price and our options are irrelevant. As such, we
recommend keeping VXX call option exposure short-dated (e.g. 1 month or less to expiry) and
only buying these when we are highly confident of an imminent increase in volatility. There
are very few cases when it makes sense to buy long-dated VXX calls as opposed to a different
type of hedge.
VXX 2014-2015
45.0

40.0 30 strike VXX calls

are relevant here...

35.0

30.0

25.0
...but are no longer
as relevant here

20.0

Source: Macro Risk Advisors, Bloomberg

15.0
Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
7 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640
 If we buy call options in the VIX, we face a similar problem of decay as VIX futures “roll
down” the curve. This problem is pronounced for long-dated VIX options. Even if we get a vol
spike, we find that long-dated VIX futures are generally not very reactive. The good thing
about VIX options is that the strikes are meaningful because the VIX has a “range” (while
VXX prices are meaningless in the long term and highly path-dependent).

Most importantly, we need to compare the cost of long-dated VIX calls with the potential cost
(and reward) of rolling near-dated VIX calls. If we think volatility increases by the end of the
year but don’t know exactly when, it may be a better trade to roll near-dated VIX calls rather
than buy long-dated VIX calls. The decision will come down to the shape of the VIX curve and
our view on the future path of volatility.

Conclusions
• Volatility can’t be “owned” like a stock or a bond.

• You need to trade derivatives (or ETFs tracking them) to have exposure to volatility.

• All volatility bets have a time limit.

• Long exposure to volatility costs money. You pay money to be long volatility and are paid
money to be short volatility.

• Options can’t be free. By extension, the VIX can never be zero.

• We can’t buy the VIX. If we could, we would always buy the VIX when it is low, because we
would be guaranteed to eventually make money (since it can’t go to zero).

• The VIX futures curve is upwards sloping in “normal” times, and downwards sloping in
times of market stress.

• The VXX can decrease infinitely, and has no low. Unlike VIX prices, VXX prices are
meaningless, and only make sense in relation to a previous or future price (since the VXX
price reflects a portfolio’s value).

Strictly Confidential.
Strictly Confidential. Pravit Chintawongvanich
8 Duplicate
Do Not Do Not Duplicate or Distribute.
or Distribute.
Contact: 212-287-2640