Why do Volatility ETPs decay? It's NOT "Sell Low Buy High"

Video Transcript:

The long volatility products like VXX and UVXY, they've been around for many years now and pretty much everybody at this point knows that they do decay downward long term. The VXX, for example, has gone down an average of 48% a year. But of course, if we want to make money trading these things, we first have to understand exactly what's causing them to go down, right? All volatility traders need to watch this three-part video series.

Now, in the second video, I'll talk about roll yield and why that is one of the main drivers of the long-term decay factor. In video three, we'll go over beta slippage, which does affect several of the volatility ETFs, both long and short. But we can't talk about those until we debunk one of the most common misconceptions in the volatility product space, the old buy high, sell low daily rebalancing myth.

Sound familiar? Unfortunately, it's complete BS, so let's put this one to rest. So in order to debunk this very frustrating myth that just won't die on social media, we first have to do a very quick explanation of how volatility ETFs like VXX actually work. What we've got here is a very normal, stable looking term structure.

Really quick, each one of these points represents a monthly VIX future going out in time. And the VXX, for example, it holds a combination of only the front two month VIX futures. We call those M1 and M2.

At the beginning of the monthly cycle, it'll be holding 100% of M1 and 0% of M2. Then at the end of that first day, it's going to rebalance about 5% of its holdings from M1 to the M2. So at the end of day rebalancing, it's going to sell a little bit of this first one and then use that capital to buy a little bit of the second one.

It does this every day until the last day of the cycle, it will have fully rebalanced to the back month, now holding 100% of M2 and 0% of M1. Then the front month M1 expires, all the futures move forward a month and the cycle starts again. At the end of the day, there is a rebalancing process that takes about 5% of capital from M1 futures to the M2 futures.

This is where that big myth comes in. Because if you listen to some of these people on social media, they say that because the VXX is selling some of this cheaper M1 future and buying the more expensive M2 future, that this is somehow realizing a capital loss in the rebalancing. I've even heard those people say that you should sell your shares before the rebalancing and buy them back afterwards.

Like you can somehow avoid this chunking of the price downward. This is a ridiculous myth that really needs to die. There is no loss of capital due to the daily rebalancing.

The entire thing is a net zero transaction that has no effect on the underlying volatility product. We can prove this very simply. So first we'll do a basic stock example because everybody will agree on this one.

And then after I'll show you why the exact same concept applies to volatility ETFs. So we're just going to do a two-stock demonstration here and we're going with a portfolio value of $100,000. So imagine a trader has $100,000 and 80% of it is in NVIDIA and 20% of it is in Apple.

Maybe they think, well, NVIDIA has been on a pretty decent run. We're going to do a little bit of a rebalancing here. We're going to sell 5% of our NVIDIA shares and we're going to move that capital and buy 5% of Apple shares.

And the question is, will the $100,000 actually change value due to a rebalancing? Don't get ahead of me here. This is important to go through for a lot of people. So if we change this one to $75,000 and this one to $25,000, it's pretty obvious that is not going to change the value of my stock portfolio.

That rebalancing did absolutely nothing. I just took some money from here and I put it over here. So with those numbers and a two-stock portfolio, this couldn't be any more obvious, right? Moving capital from one pile to another does absolutely nothing to the value of the portfolio.

It doesn't matter if one of them is more expensive than the other one. That's irrelevant. Now, what does affect the value of the portfolio, of course, is what happens after the rebalancing takes place.

Well, now it's a freely traded market and those prices are going to be moving around. And of course, that is going to affect the value of the portfolio. The rebalancing itself, net zero transaction.

So now let's go over what happens when the VXX does its daily rebalancing. So using the numbers from this day, the M1 VIX future is 15.611 and the M2 is 17.024. The second month is clearly a much higher price than the first month. So we can put those numbers here in our portfolio.

And then the VXX, it currently has AUM of about 330 million, but I'm going to use 300 million here just so visually we can see right away what's happening. So we're going to assume the same thing, end of day rebalancing and currently the M1 future has 80% and the M2 future has 20%. Remember, at the end of the day, it does have to transfer about 5% of the capital from M1 to M2 as we move forward through the cycle.

So same thing, we're going to sell 5% of this one and we're going to buy 5% of that one. So did that change the AUM, the NAV value, the price of the VXX itself? No, of course not. All that happens is you're moving money from here to here.

The number of shares will change of each one of those futures, but the actual value is exactly the same. Just like with the two-stock portfolio, the only thing that changes the value of the VXX is what happens outside of that rebalancing window. So just for the sake of argument, let's assume that that rebalancing takes one second to do at the end of the day.

Well, nothing happens during that one second. We've seen that already. Value just goes from one pile labeled M1 into another pile labeled M2.

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It's a net zero transaction. The price of the VXX is the same before and after the rebalancing. The reason the VXX decays is everything that happens during the other 23 hours, 59 minutes, and 59 seconds, right? That's what we want to focus on if we want to actually profit from the short volatility trade.

The one or maybe the two things that actually are influencing the price of these volatility products. So now that the daily rebalancing from cheap future to expensive future is totally debunked, that's a net zero transaction. Don't even worry about that.

Our next video can start talking about the roll yield, and that is affecting the price of VXX. And then in video three, we'll talk about what happens if the volatility product itself is using leverage, like the UVXY, for example. We will tackle the concept of beta slippage in video three.

All volatility ETP trading at some point comes through those VIX futures expiration cycles. So check out this video because you definitely need to understand that. If you want to be an expert volatility trader, the secret lies in those VIX futures.

See you next time.