Volatility ETFs Explained: UVXY | VXX | SVXY

Video Transcript:

(0:00 - 0:17)
If you want to make money shorting the volatility ETFs like UVXY and all the rest of them, this is the investing opportunity of a lifetime, but you have to understand how they work. We're not guessing on which direction they're going to move here. There's an underlying methodology determining the pricing, and we can take advantage of this expected decay path.

(0:17 - 4:59)
But you have to cut through all the misinformation out there and really understand the process. So that's what we're going to do today. Give the video a like for me if you want to see more volatility content like this, and let's get into it.

So it all starts with the VIX futures term structure. Now, I don't want to waste any time in this video talking about how this thing works. I've got an entire video breaking down the VIX futures expiration cycles.

It's only five minutes, so make sure you do go watch that video after this one. But the VIX futures are everything here. The number one thing people have to understand about the volatility products, and it's understandable why this confuses people, it's very unique.

But the volatility products like UVXY, for example, they don't derive their price based on supply and demand of the UVXY itself. When you're trading any other stock or ETF, the price is determined by how many people are buying and selling the security, right? But with volatility products, it doesn't matter how many people are buying or selling them. That's not going to move the price.

Now, I know that sounds very strange, but volatility products track an underlying index. And then they have what's called authorized participants who are able to create or redeem shares to make sure the volatility ETPs are correctly tracking their underlying index. So if we look at one of those indexes, this is called the SP VIX STR.

This is the underlying index for the original volatility product called VXX that launched in January 2009. Now, the VXX itself is a very diabolical looking chart. It obviously goes down long term.

But remember, it's not because a whole bunch of people are selling this thing, and it's really unpopular. That's not what's happening. The VXX is going down because it's tracking an underlying index that holds VIX futures.

And those futures themselves are decaying and losing value most of the time. So this chart of the VXX and this chart of the SP VIX STR index, they're the same thing. The 1x non-leveraged VXX tracks this SP VIX STR index.

The UVXY, a 1.5x leverage volatility ETF, it also tracks this SP VIX STR index. But it just does it with 1.5x daily leverage. Again, remember, it's not supply and demand.

If we scroll down a bit, we can see it explains the basic methodology here. The S&P 500 VIX short-term futures index utilizes prices of the next two near-term VIX futures contracts to replicate a position that rolls the nearest month VIX futures to the next month on a daily basis in equal fractional amounts. This results in a constant one-month rolling long position in first and second month VIX futures contracts.

Now that does sound a little bit complicated, right? But trust me, give me a couple minutes here, I can explain this way better than that website can. So like I said, it all starts with the VIX futures term structure. Now every one of those dots is a monthly VIX future.

Traders can buy and sell these depending on where they think volatility will be going forward. So the first one, M1, is for December and they go all the way out to August. Again, watch that other short video I made about how this all works.

But for this example, we're going to start on December 19th, 2023. The reason we'll start here is because you can see this M1 December contract has zero days to expiration. This is the last moment before that front month VIX future expires.

So remember, the VXX tracks a constant one-month rolling VIX future based on these front two, M1 and M2. But since we're looking at the final moment right before expiration, the VXX is actually holding 0% of the front month future M1 and 100% of the second month future M2. So just at this last moment, it's 0% M1 and 100% of M2.

And then the M1 future is going to expire and be removed from the board completely. So watch when I click over one day. You'll see the M1 disappear and the M2 becomes the new M1.

You see that? The whole expiration cycle starts over again. And remember, VXX was already holding 100% of its VIX futures on this one here. So on the first day of this new cycle, VXX was already holding 100% of the future that now becomes the new M1 and 0% of the next future that now becomes the M2.

So far, pretty simple, right? But this is where it gets interesting. Remember, the methodology is to track a constant one-month rolling VIX future. As time goes by, if the VXX continues to just hold 100% of the front month M1, then with each passing day, it's not going to represent one month anymore, is it? It'll be 29, 28, 25, 20 as the days and weeks go by.

So to make sure that it remains a constant rolling one-month VIX future, every single day at the end of the day, they have to do a rebalancing of the futures that they hold. So every day, the VXX is going to sell a little bit of the front month M1 VIX contract and move that same amount of capital over to the back month M2 VIX contract, just a little bit each day. Now we can actually determine how much each day.

(4:59 - 8:10)
I track all this in my spreadsheet. So if we go to this cycle we're talking about here, this is December 19th. If we go over here, we can see this is the last day before expiration.

And then it expires, the new cycle begins, and the next cycle for this period had 17 days. The SPVIX STR index rolls its futures in equal fractional amounts. So 100% divided by 17 trading days, it means that it's rolling 5.88% per day.

With each passing day, the VXX is going to sell 5.88% of its front month VIX future M1 and take that capital to buy 5.88% of back month VIX futures M2. It's going to be doing this every single day throughout the cycle. At this point, I do need to stress something.

This daily rebalancing is not the reason the volatility ETPs decay long term. Unfortunately, there's people out there that write articles about the volatility products, but they have no idea what they're talking about. They're just spreading misinformation.

I'm going to make this part an entire separate video because it's that important. I need to debunk this idea that the UVXY is decaying because it's somehow selling cheap futures contracts and buying expensive ones. Again, I stress that is not affecting the pricing and there's a whole video coming that I will explain all that.

So remember for this cycle, every day the VXX is selling 5.88% of M1 and taking that entire amount of money and buying 5.88% of M2. As we're clicking through these dates, notice the weightings are slowly moving from the front month future to the back month future. That's that 5.88% of equal fractional increments every day.

Now if we stop halfway through, right in the middle of the cycle, now the VXX is holding 50% of the front month M1 and 50% to the back month M2. So that constant one month VIX future is right there in the middle of these two, middle of the cycle. We can continue all the way to January 16th.

And now on January 16th, this is the last moment before expiration. So now since the VXX has been selling the front month M1 futures and buying back month M2 futures every day, on this last day it's now holding 100% to the back month M2 and 0% to the front month M1. This daily rebalancing is how it keeps the one month constant VIX future.

Now if I click over one more day, you'll see the front month M1 disappear and the future that was the M2 now becomes the new M1. There it is, a fresh new cycle. And VXX is now holding 100% of the new M1 and 0% of the new M2.

This whole cycle is going to repeat again. Now every cycle does have a different number of days. You can see the one after the one we were looking at, this cycle has 20 days.

So the daily rebalancing for that month would be exactly 5% every day. Moving forward, rebalancing 5% from front month to back month every day, making sure that it's a constant one month VIX future that we are tracking. That's what the underlying index tracks.

Like I said, supply and demand means nothing here. The VXX is actively managed to make sure that it's tracking that SPVIX STR index. The UVXY tracks that same SPVIX STR index at 1.5x leverage.

(8:11 - 8:40)
The SVXY is a minus 0.5x short volatility ETF and it tracks an index called the SPVIX SP5I. The new UVIX, the 2x long volatility product, it tracks an index called long vol. The minus 1x leverage SVIX, that tracks an index called short vol.

The VXZ and VIXM, they track with 1x leverage the SPVIX MPIT index. It goes down the list. Every volatility product tracks an underlying index.

(8:40 - 9:25)
You can see supply and demand has nothing to do with this. It is a preset methodology. This means your technical analysis won't work with volatility ETPs.

They are just derivatives of something else. For our purposes, we need to understand how the volatility ETPs work so that we can use that information and actually predict their forward movement based on the current volatility environment. Like I said, the trading opportunity of a lifetime for those that take the time to understand this stuff.

This video here explains the entire VIX futures expiration cycle process, so you definitely want to watch this video as well. Or you can watch this video here that explains our flagship tactical volatility strategy and how we've actually made 30% a year since we launched in January 2012. See you next time.