Too Err Is Blog-Human

• Posted by Adam Warner
• on July 22nd, 2010

Upon further review, I erred in my analysis of this new XXV. The nickel version is that unlike the levered and inverse levered ETF’s we know and love, XXV uses the original offering price as a basis. I incorrectly assumed they use the day over day change like the TZA’s and SSO’s of the world.

The implication is very interesting. XXV will not gradually drift lower, but it might abruptly crash lower. It also may provide a decent holding over time.

Let me explain that all.

Here’s how they calculate the value of the note (XXV is an ETN) each day.

“Closing Indicative Note Value: The closing indicative note value for each ETN on any calendar day will equal (a) the principal amount per ETN plus (b) the inverse index performance amount on such calendar day plus (c) the accrued interest on such calendar day minus (d) the accrued fees on such calendar day; provided that if such calculation results in a negative value, the closing indicative note value will be $0.”

For the purposes of our analysis, we’re going to disregard (c) and (d).

The principal amount was $20, so that’s (a). And for (b), they give us this definition.

“Inverse Index Performance Amount: On the initial valuation date, the inverse index performance amount for each ETN will equal $0. On any subsequent calendar day, the inverse index performance amount for each ETN will equal the product of (a) negative one times (b) the principal amount per ETN times (c) the index performance percentage on such calendar day. “

So the index performance is equal to (-1) x (20) x (index performance percentage). They define “index performance percentage as “on the initial valuation date will equal 0%. On any subsequent calendar day, the index performance percentage will equal (a) (i) the closing level of the Index on such calendar day (or, if such a day is not an index business day, the closing level of the Index on the immediately preceding index business day) divided by (ii) the closing level of the Index on the initial valuation date minus (b) 100%.”

Throw that all together, and here’s the formula to calculate XXV on any given day. The “20″ in the formula is the principal amount of XXV, the “27″ is the (approximate) price of VXX on the day of the offering.

It’s (20  + (-1 * 20 *((VXX/27)-1)).

So now let’s use an example of price action similar to the one I used in my original posting.

On Day 1, VXX lifts 10%. That produces a closing price of 18 for XXV. Pretty straighforward. On Day 2, VXX lifts another 10%, for a net rally of 21%.  Throw that in the formula, and XXV is now worth 15.8. That’s down 12.2% for the day, a day in which VXX lifted 10%. So as you can see, this pup will get disproportionately ugly in a VXX rally.

Now how about on Day 3 we take VXX all the back to 27, where it started. That’s a 17.3% 1 day drop. In response, XXV does actually bounce back right to 20. That’s a rally of 26.5% in response to a 17.3% drop in VXX.

Get the picture?

The implications I see are as follows.

There’s no compounding math problem here, XXV will not drift over time per se. It might crash though as you can see it will have exponentially uglier reactions to VXX rallies when XXV is below 20. If VXX roughly doubles from where it was when they set the XXV principal amount, then XXV goes to 0. I say “roughly”, because I didn’t account for accrued interest or expenses in this example.

But here’s the good news. It’s very tough to envision a scenario where VXX doubles. On a day to day basis, it has to overcome the contango issue we’ve gone over. In a VIX explosion, that contango issue will evaporate as the term structure inverts. But that’s because VIX futures will not lift as much as the VIX, which is actually a worse situation for VXX.

I’m loathe to make judgments on a product 3 days into it’s life, so take this with a serious grain of salt. Especially since I analyzed it incorrectly the first time. But I believe you can hold this pup if you’re so inclined to bet against VXX. Always keep the dangers in mind, i.e. the potential for a compounded reaction to a VXX lift.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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