It doesn't make sense. These are supposed to reproduce the one day performance of whatever index they are tracking. So the value one day to the next is pretty much completely arbitrary. It's the trend that matters. If that is true (and it may not be true), how would you even begin to price a 50 strike? Please help me understand what I am missing. I have read the prospectus and came away none the wiser.
What do you mean by arbitrary? They're based off VX futures. You can replicate the historical prices of VXX/UVXY from the front 2 months of VX. Pricing options on them is like pricing options on any other stock. It's a regular time series and you can measure its volatility. You'd also need to account for contango/backwardation of the futures when computing the forward price, but that's about it.
Yes but if the index is just aiming for same day performance, the drift must be crazy no? Do you have any experience replicating the price?
The NAV of UVXY (1.5 levered) at time t is roughly : NAV(t) = NAV(t-1) * ( 1 + 1.5 * IDX(t)) Where IDX(t) is the return from t-1 to t of the underlying index (the VIX index). I think the drift you're referring to is what happens as IDX(t) has volatile returns. One can show that NAV(t) has decay relative to an unlevered product.
I think this is what I was missing in my understanding. Thanks. What are the practical implications here, do you think?
- The "decay" which is cause by the daily replication might need to be accounted for in the forward price. - It also means one can hedge into any product that tracks IDX. But may need to be rebalanced on a daily basis as is UVXY. - The volatility if UVXY can be written as a function of IDX
Yes, it's just a weighted average of the daily returns from the front 2 month futures (so the maturity is always 30 days), adjusted for fees. The drift on VXX is due to the contango on VIX futures (even they generally decay over time), while UVXY has contango + leveraged ETF decay. Both these effects are measurable and can be adjusted for in the forward price.
It's the decay that makes me wonder how people can price options on UXVY given the inherent tracking error over time. For example, the error according to this site puts UXVY in the 27th percentile for tracking error (for comparison, SPY is 98th percentile). Effectively, what this means is a UXVY price of $50 in January 2019 is very different from a UXVY price of $50 in January 2020. So htf do you price options...
I understand you're saying it can be measured and adjusted... But over a year or two? I don't see how.
If youre making UVXY options then you're probably hedging delta, so you wouldnt really need to model where the underlying will be in a year or two.