In today’s episode of “Tweets that show a broad misunderstanding of a tradable volatility product,” I bring you this:

“You could argue that the 18mo chart for $VXX shows things were super-crazy Jan 2009 and that we are too complacent right now.”

The iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) is a derivative product that tracks a rolling 30-day CBOE Volatility Index (VIX) future. It is purely a trading vehicle.

As we have noted, if the VIX is in contango (an upward sloping futures curve), then VXX will lose modest money every day rolling from the shorter-term future to the longer (and higher priced) one. And VIX is virtually always in contango, which almost guarantees that VXX will underperform the VIX itself over time.

In other words, let’s say the VIX was at 40 and VXX was also at 40 at some time in the past. Now, over the course of time, the VIX declines to 20, but rebounds back to 40. VXX will almost certainly be lower than 40 on that second trip back to 40. That’s thanks to the contango drag from constantly rolling to higher futures.

Here’s a chart of the VIX over the past year:

And here’s VXX:

In late January, the VIX spiked to 27.5, and VXX peaked at about 32. When VIX returned to 27 again in the early May explosion, VXX was about 29. But currently, with the VIX again near 27, VXX is “only” 27.

This is due to the fact that contango gradually erodes VXX. Quite simply, VXX is a derivative product. It’s a nice trading vehicle, but absolute levels are utterly meaningless. The VIX itself is often difficult to compare to readings of the not-so-recent past. VXX is impossible to compare, so don’t even try.

Other trading vehicles with the same contango problem are energy ETFs United States Natural Gas Fund, LP (NYSE: UNG) and United States Oil Fund, LP (NYSE: USO). They just have a different methodology, as they roll monthly, and if in contango, will lose each time. Compare USO to West Texas Intermediate (WTI) light sweet crude oil and you’ll see it’s similar to VXX’s relationship to the VIX.

Follow Adam Warner on Twitter @agwarner.

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