How Do SVXY and VXX Work? Volatility (VIX) ETFs Explained

Spark Global Limited reports:

Outright speculation on future volatility is a fairly new phenomenon in financial markets.

The mathematicization of derivatives markets has made traders realise that they are largely betting on future volatility, not prices, encouraging Wall Street to create more “pure game” products.

The main volatility products in the US market are VIX futures/options and exchange traded products (ETPs) that mimic VIX futures positions.

Direct VIX derivatives have existed for more than a decade, but it was only after the 2008 financial crisis that they began to see sufficient liquidity.

As a result, ETF managers have created their own volatility derivatives in the form of etPs similar to those used to trade stocks. As of today, the two major VIX ETPs are SVXY and VXX.

Before we continue, let’s take a look at the VIX index and how it works.

VIX index interpretation
VIX refers to the STANDARD & Poor’s 500 Volatility Index.

The calculation shows how s&p 500 options traders expect volatility over the next 30 days.

VIX incorporates various short-term S&P options contracts into its calculations and looks at price movements.

When the VIX is 20, what does that mean? That means market expectations for volatility over the next 30 days are running at an annualised rate of 20 per cent. That’s based on the price of the option. The more expensive the options (insurance), the higher the VIX.

The financial press has dubbed the VIX the “fear index” and options traders have pounced on it, but for the most part it’s true.

Most of the time, the S&P 500 and VIX are inversely correlated, meaning that when the S&P falls, the VIX rises. Why is that? Because the market to take the stairs, take the elevator. When the market started to plummet, people started buying insurance (options) to protect their portfolios.

When everyone buys insurance at the same time, prices go up.

Remember, the VIX is just an index. You can’t trade it directly, nor is it practical to re-establish an exact option portfolio.

There are VIX futures, VIX options and VIX futures, all of which have very liquid markets. You can trade them, but they may change hands at a different price than the actual index.

What is the ETN?
It’s worth noting that VXX is not an exchange-traded fund. It’s an exchange-traded note, or ETN.

This difference may sound trivial, but it is actually very important for these purposes. An ETN is an unsecured debt note issued by an ETN manager, which means there is a credit risk, whereas a normal ETN has no credit risk.

So keep in mind that there are external factors that can affect the value of an ETN.

What is SVXY? How does it work?
SVXY is a systematic ETF that shorts the front end of the VIX futures curve, particularly in the first two months. The product is managed by ProShares and structured as an ETF rather than an ETN.

If you don’t know what a VIX curve is, I’ll explain.

A futures contract is an agreement to trade at a locked price on a specific date in the future.

For example, if I buy a July 20 VIX futures contract, I agree to settle the difference in cash by that date if I remain the contract owner on that date.

If I buy futures at $20, which is $18 at maturity, I have to give my counterparty, the seller of the trade, $2.

In the futures market, there are several different maturities.

If you are a farmer and want to hedge next season’s crop, it doesn’t make much sense to hedge it with next month’s futures contract. If you’re a short-term trader, hedging next year’s futures doesn’t make much sense. So there’s a lot of expiration dates.

The VIX futures curve is a price sequence of different futures contract maturities. Here’s an example from VIX Central: