The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN) designed to provide investors with exposure to equity market volatility. Shares of an ETN, which is structured as a debt instrument, can be bought and sold like shares of stock.

During times of high volatility in the stock market, the value of VXX shares will typically increase. On the other hand, quiet periods for the market will likely keep shares trending lower. Here’s why.

Understanding VXX

The iPath S&P 500 VIX Short-Term Futures ETN is legally structured as an exchange-traded note (ETN), which is similar in nature to an exchange-traded fund (ETF). The main difference between an ETF and an ETN is that, while the exchange-traded fund represents ownership in a basket of securities—stocks, bonds, or commodities—within the fund’s portfolio, the exchange-traded note is an uncollateralized debt instrument and has bond-like characteristics: investors can hold shares until maturity (which is Jan. 23, 2048, for the VXX ETN launched Jan. 19, 2018) and buy and sell before maturity.

Managed by Barclays Capital Incorporated, the iPath S&P 500 VIX Short-Term Futures ETN is linked to the daily price changes in Cboe Volatility Index, but in a complicated way. VIX is sometimes called the market’s “fear gauge” because it tends to rise during periods of market uncertainty and spike in times of panic. The index tracks changes in the expected volatility priced into S&P 500 Index options and is computed using an options-pricing formula.

Futures contracts are listed on Cboe Volatility Index, and VXX is an ETN that tracks the S&P 500 VIX Short-Term Futures Total Return Index, which is designed to offer exposure to long positions in Cboe Volatility Index futures contracts. Therefore, VXX does not track VIX itself (spot VIX), but the futures on VIX, which often trade at very different price levels depending on the time to maturity.

Risks

Since VXX must roll its futures contracts to rebalance the fund to the later contract, the fund manager is forced to sell the futures contracts that are closest to their expiration dates and buy the next dated contracts, which is a process called rolling. Since longer-dated futures contracts are often at higher levels than shorter-dated ones (during normal market conditions), the rolling activity can result in losses (as the ETN is forced to sell the lower-valued contracts and buy the higher-priced contracts).

The iPath S&P 500 VIX Short-Term Futures ETN can be influenced by many unpredictable factors, and the price of VXX can fluctuate substantially between now and the maturity date. Influential factors include prevailing market prices of the U.S. stock market, S&P 500 Index options prices, supply and demand for VXX, as well as economic, political, regulatory or judicial events, or changes to interest rate policies. Basically, anything that affects stock prices can also affect volatility and VXX shares.

The Bottom Line

An investment in VXX might be suitable for investors who want to hedge their portfolios against a market downturn and speculators who have a high risk tolerance. However, since the iPath S&P 500 VIX Short-Term Futures ETN is only composed of derivative contracts, individuals should understand the Cboe Volatility Index and VIX futures before investing or trading the exchange-traded note.

Traders and analysts rely on a variety of different indicators to track volatility and to determine optimal exit or entry points for trades. While high volatility is often a deterrent for a risky trade, increased fear during extreme market moves can also create buying opportunities and provide an exceptional trading ground for experienced investors.

On the other hand, periods of low volatility—accompanied by investor complacency—can warn of frothy market conditions and potential market tops. Some of the most commonly used tools to gauge relative levels of volatility are the Cboe Volatility Index (VIX), the average true range (ATR), and Bollinger Bands®.

Cboe Volatility Index

The Cboe Volatility Index is one of the most widely watched gauges of market volatility. Updated throughout the trading day and known by its ticker symbol, VIX, the index is computed using an option-pricing model and reflects the current implied or expected volatility that is priced into a strip of short-term S&P 500 Index options.

Because large institutions account for a large portion of trading in S&P Index options, their volatility perceptions (as measured by VIX) are used by other traders to help get a reading of likely market volatility in the days ahead.

The Cboe Volatility Index stays between 12 and 35 the majority of the time, but it has also dropped into the single digits and has rallied to more than 75. Generally, VIX values higher than 30 indicate increased volatility, while values in the low teens are indicative of low volatility.

Derivatives, such as futures and options, on VIX are actively traded. In addition, leveraged exchange-traded funds based on the volatility index—like the ProShares Ultra VIX Short-Term Futures ETF (UVXY) and its partner ProShares Short VIX Short-Term Futures ETF (SVXY)—exist as well.

Average True Range

While VIX measures S&P 500 volatility, the average true range indicator, developed by J. Welles Wilder Jr., is a technical chart indicator that can be applied to any stock, exchange-traded fund, forex pair, commodity, or futures contract. ATR calculates what Wilder called “true range” and then creates the ATR as a 14-day exponential moving average (EMA) of the true range. The true range is found by using the highest value generated by one of three equations:

True range = Current day’s high minus the current day’s low
True range = Current day’s high minus the previous day’s close
True range = Previous day’s close minus the current day’s low

The ATR is then created as an EMA (computed using the highest value found when the three equations are solved). A larger ATR indicates higher trading ranges and thus increased volatility. Low readings from the ATR are generally consistent with periods of quiet or uneventful trading.

Bollinger Bands®

Bollinger Bands® is another charter indicator and consists of two lines or bands, which are two standard deviations above and below the 20-day moving average, which appears as a line in between the two bands. Widening of the bands shows increased volatility, and narrowing of the bands shows decreased volatility. Like ATR, Bollinger Bands® can be applied to any stock or commodities chart.

The Bottom Line

Market volatility goes through cycles of highs and lows. Analysts watch the direction of market movement when there is a sharp increase in volatility as a possible indication of a future market trend. While VIX is useful in seeing overall levels of volatility of the S&P 500 Index, ATR and Bollinger Bands® can be applied to stocks, commodities, forex, indexes, or futures using any number of charting applications.