Holders of the VIX Futures ETN (NYSEARCA:VXX) have watched the value of the security deteriorate considerably since the November elections. The VIX futures curve had previously been in a sharp contango which has persisted since November 4th, 2016 and the contango lasted all the way until April 5th, 2017. The graph below shows this pictorially.

What this graph shows that when the front month futures of VIX are higher than the current month (think May futures vs April futures), the value is greater than zero. When the front month value rises (often as a result of higher equity volatility), the curve goes backwardized. This is similar to the “inverted yield curve” you may have heard of in the past.

For those holding VXX, a contango situation results in losses. This is because VXX is designed to buy futures a month out and cover them near expiry and reshort the futures to the following month. Since April 5th, things have changed. As seen in the graph above, the VIX curve is now backwardized and as a result, the VXX ETN has gained over 6%.

Now many of you may be wondering, and rightly so, why the curve has been backwardized for so long while equities have been relatively well behaved. The S&P 500 (NYSEARCA:SPY) is virtually flat, the Nasdaq (NASDAQ:QQQ) is up 0.45% in the same time frame. In fact, the VIX has only closed over 15 three times since November 9th!

The answer lies in how the VIX curve has been priced recently. You may have heard of the various strategies investors and algos have been utilizing over the past several months to take advantage of the expectation of lower volatility as a result of the reflation trade. The way this is achieved is by going short the VIX curve at a date one feels comfortable.

Here is a background on how this trade can be executed: If I expected the VIX to settle at 15 around next months expiry and the current price of the May VIX future is a 16, I would short the May future and pocket ~6% if I am right. If the VIX settles at 16, I breakeven, if it settles below 14, my profits rise and if it settles above 16, I would expect a loss.

Make sense? Please re-read if it doesn’t.

Now there are times when it makes a lot of sense to short the VIX futures. This is typically when volatility is priced at levels you do not expect to last. It also makes sense to short VIX when you feel that the VIX curve will remain in a contango between the time you put on the short VIX trade and when you cover.

Unfortunately, the lure of easy money has attracted humans and machines alike into this trade. What they have accomplished is a severely depressed VIX curve which also happens to be quite flat.

The graph below shows the curve today versus what it looked like six months ago.

As you can see below, the price expectation for those shorting the June futures is that the VIX will settle below 14 in order for them to realize a profit. Whether or not it doesn’t, I don’t know. What I do know is that it doesn’t take much for the VIX to spike to 20 or 25 or 30 when the market is as jittery as it is today. However, that is what the current situation is. Six months ago, the front months were priced at 15 and 16 when the spot was realizing only 13 which represented a sharp rolldown.

The key takeaway here is this.

  • There remain sizeable shorts in the VIX futures.
  • The pricing on the VIX futures implies expectation for lower realized volatility than 14
  • The curve is backwardized on a short term basis

All three takeaways mean that there remains a decent probability that the VXX ETN may continue notching gains in the near term. This would change if there are events which result in the curve getting repriced. Until such a time where a sharp contango is re-established, VXX continues to look somewhat appealing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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