Why does VXX go down? VIX Futures Roll Yield Explained

Video Transcript:

Welcome back everybody to lesson five of this volatility ETP course. Now I have linked all the previous videos down below so you can catch up if you're a little behind, but today we're going to talk about the very important subject of VIX futures roll yield. This subject is at the heart of all price movement for all the volatility products, so you really do have to understand this concept if you want to be a profitable short volatility trader.

So there's only two forces driving the price of volatility ETPs. One of them is called beta slippage, but that only affects the leveraged products, so we're going to talk about that one in the next lesson. But the main factor for all of them is called roll yield.

This is an example of what the VIX futures term structure looks like in a stable market. Now you can see the current one every day at vixcentral.com, but simply put, roll yield describes the relationship between the VIX futures and the VIX index itself. These VIX futures, one for every month going out in time, they are freely traded.

It's just market participants buying and selling based on where they think volatility will be going forward. The VIX index is derived from S&P 500 options activity. Now these do decouple completely throughout most of the month.

There is no direct causation here, but the reason it's so important is that remember from lesson three in this course, volatility ETPs like UVXY, VXX, SVXY, they hold a combination of only the front two-month VIX futures, M1 and M2. Their allocation between those creates a constant 30-day maturity VIX future. I call this VX30.

So remember that VX30 is the combination of only the front two-month VIX futures. At the beginning of the cycle with lots of time left to expiration, VX30 will basically be all of the front month M1 future and none of the back month M2 future. But as time goes on to maintain that 30-day constant maturity, every day they have to rebalance a little bit to the back month by selling some M1 and buying some M2.

Now importantly, and this was lesson four in the course, that rebalancing itself causes no price change at all. It's all done at a net zero transaction. But by the end of the monthly cycle, because of that rebalancing, that VX30 will be entirely made up of the back month M2 future.

So here's the punchline. This is what you need to know. Whatever direction that VX30 price goes, that's the direction the volatility ETPs will go as well.

So for the long volatility products, if VX30 goes up, then those will also go up in price. If VX30 goes down, they will decay in value over time. For the inverse, the short volatility products, it's now the opposite.

If VX30 goes up, those ETPs go down. And if VX30 goes down, those ETPs go up in price. So you can see the VX30, the combination of M1 and M2 VIX futures, is extremely important.

But now let's add another detail to the picture that will crystallize this for you. On expiration day, just for that one day, the M1 VIX future will converge to the spot VIX index price and they will be the same value. This means that it really does matter where that VX30 is in relation to the VIX index, right? If VX30 is above the VIX, I call that positive roll yield.

And if that situation were to persist for a while, as it does in a stable market, for example, then there's a high probability the VX30 price will converge down to meet the VIX index, right? If VX30 goes down, long volatility products like VXX and UVXY, they will go down with it.

But now let's look at a VIX futures term structure during a chaotic market where the S&P500 is crashing. This one here is from August 5, 2024, during that big volatility spike from the Japan carry trade nonsense.

On this day, the VIX index itself went as high as 65, which was way over where the VIX futures were trading at. Essentially, the VX30 was way below the VIX index. I call this negative roll yield.

So if this situation were to persist for a while, and in a down market or an extended recession it will, then there's a high probability the VX30 price will go up as it's converging to the VIX index, which is priced much higher than the futures. And remember, if VX30 goes up, then long volatility products like VXX and UVXY, they will go up as well. So positive roll yield is when that VX30 is trading above the VIX index, and this is going to cause those long volatility ETPs to go down as it converges to the spot VIX price.

Negative roll yield is when that VX30 is trading below the VIX index, and this is going to cause those long volatility ETPs to go up as that VX30 is going up to meet the VIX index. Now that you know the primary driver of VXX performance, it's actually pretty easy to understand why these long-term charts are so diabolical, right? The VXX has gone from a split adjusted price of over $6 million down to less than $50 now. It's down 99.9% since inception.

Based on what we know about that VX30 to VIX roll yield, we would expect that it would have to have been positive for the vast majority of the time, right? That VX30 would have to have been going down most of the time, and in fact it has been. Since the launch of VIX futures on March 26, 2004, the VX30 to VIX roll yield has been positive over 80% of the time. This is what's causing that crash in long volatility ETPs.

So the next time you're at a party and somebody asks you why is the VXX down 99.9% since inception, you can now impress everybody by saying, it's because the 30-day constant maturity VIX future called VX30 is steadily converging towards expiration to the spot VIX index price that has traded below the M1-M2 VIX futures about 82% of the time since inception. If that doesn't impress a girl, I don't know what will.

Our VTS community has been using that concept of isolating the positive roll yield to make over 30% a year in our flagship strategy since 2012.

This video here will explain everything about our Tactical Volatility Strategy. Or you can watch this video and continue down the Volatility Trading rabbit hole. See you next time.