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The ETF VXX is based on the volatility index VIX. If volatility goes up, VIX goes up and VXX goes up. Similar thing for the downside. Now when I buy an ETF like SPY, I can conceptually understand that I am buying a small portion of each of the underlying companies. So if an underlying company stock makes a move, the ETF SPY makes a move in the same direction.

But when I buy VXX, what exactly is the underlying? It is VIX. I am unable to grasp the concept of 'volatility' as the underlying. I can visualise only stocks and commodities as the underlying because in my understanding, the unerlying needs to be something physical (let us say stocks are physical commodities for this example).

Can someone explain the concept of 'volatility' as the underlying?

Is the word 'underlying' even appropriate in this case or is the word 'underlying' only to be used for derivative products?

  • Hmm I just tried to explain VXX to someone earlier this week, do we work together? – CQM Feb 6 '14 at 3:06
  • No i don't think so :). – Victor123 Feb 6 '14 at 14:46
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The VIX is a mathematical aggregate of the implied volatilities of the S&P 500 Index components.

It itself cannot be traded as there currently is no way to only hold a position on an implied volatility alone. Implied volatility can only currently be derived from an option relative to its underlying. Further, the S&P 500 index itself cannot be traded only the attempts to replicate it. For assets that are not tradable, derivatives can be "cash settled" where the value of the underlying is delivered in cash. Cash settlement can be used for underlyings that in fact due trade but are frequently only elected if the underlying is costly to deliver or there is an incentive to circumvent regulation.

Currently, only futures that settle on the value of the VIX at the time of delivery trade; in other words, VIX futures holders must deliver on the value of the VIX in cash upon settlement. Options in turn trade on those futures and in turn are also cash settled on the value of the underlying future at expiration.

The VXX ETF holds one to two month VIX futures that it trades out of before delivery, so while it is impossible to know exactly what is held in the VXX accounts unless if one had information from an insider or the VXX published such details, one can assume that it holds VIX futures contracts no later than two settlements from the preset. It should be noted that the VXX does not track the VIX over the long run because of the cost to roll the futures and that the futures are more stable than the VIX, so it is a poor substitute for the VIX over time periods longer than one day.

"Underlying" now implies any abstract from which a financial product derives its value.

  • Thank you, but I did not understand very well:(. What exactly am i buying when i buy VXX? – Victor123 Feb 6 '14 at 0:26
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To understand the VXX ETF, you need to understand VIX futures, to understand VIX futures you need to understand VIX, to understand VIX you need to understand options pricing formulas such as the "Black Scholes" formula

Those are your prerequisites. Learn at your own pace.

Short Answer: When you buy VXX you are buying the underlying are front month VIX futures. Limited by the supply of the ETF's NAV (Net Asset Value) units. It is assumed that the ETF manager is actually buying and selling more VIX front month futures to back the underlying ETF.

Long Answer: Assume nobody knows what an options contract should be worth. Therefore formulas have been devised to standardize how to price an options contract. The Black-Scholes formula is widely used, one of the variables in this formula is "Implied Volatility", which basically accounts for the mispricing of options when the other variables (Intrinsic Value, delta, gamma, theta...) don't completely explain how much the option is worth. People are willing to pay more for options when the perception is that they will be more profitable, "implied volatility" tracks these changes in an option's demand, where the rest of the black-scholes formula creates a price for an option that will always be the same. Each stock in the market that also trades standardized options will have implied volatility which can be computed from the price of those options.

The "Volatility Index" (VIX), looks at the implied volatility of MANY STOCK's options contracts. Specifically the "implied volatility of out the money puts on the S&P 500". If you don't know what that quoted part of the sentence means, then you have at least five other individual questions to ask before you re-read this answer and understand the relevance of these followup questions: Why would people buy out-the-money puts on the S&P 500? Why would people pay more for out-the-money puts on the S&P 500 on some days and pay less for them on other days? This is really the key to the whole puzzle.

Anyway, now that we have this data, people wanted to speculate on the future value of the VIX. So VIX futures contracts began trading and with it there came a liquid market. There doesn't need to be anything physical to back a financial product anymore.

A lot of people don't trade futures, retail investors have practically only heard of "the stock market". So one investment bank decided to make a fund that only holds VIX futures that expire within a month. (front month futures). They split that fund up into shares and listed it on the stock market, like alchemy the VXX was formed.

Volatility studies are fascinating, and get way more complex than this now that the VXX ETF also has liquid options contracts trading on it too, and there are leveraged VIX ETF funds that also trade options

  • Thank you, it helps when the prerequisites are laid out like that. I will educate myself – Victor123 Feb 6 '14 at 14:47

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