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Market Makers in Options Trading: What Do They Do?

Market Making

Market Maker Definition: A market marker acts as a liquidity provider by both buying and selling a security to satisfy the market. 

Market makers are the backbone of all public markets. Without them, it would be very difficult indeed to both enter and exit any type of security, including stocks, options (derivatives), ETFs, and futures. 

If you’ve ever placed a market order before, you’ve probably been surprised at how fast that order was filled. This is because a market maker was waiting, armed with a software-based trading system using algorithms, to take the other side of your trade. 

In this article, we will explore the function of market makers, and how they contribute to the smooth running of our capital markets. 

              TAKEAWAYS

 

  • The function of a market maker is to provide liquidity for the markets. 

  • Market makers make money from the “spread” by buying the bid price and selling the ask price. 

  • Market makers hedge their risk by trading shares of the underlying stock.

  • Citadel and Virtu are the largest option market makers. 

  • A broker acts as an intermediary, facilitating orders from buyers and sellers; a market maker provides order execution.

What Is the Purpose of Market Makers? 

Market makers are the reason our market orders get filled instantaneously. They also (eventually) fill stop orders, limit orders, and virtually any other type of order your broker offers. Without market makers, you would have to sit on the order until another counterparty came around and decided to take the other side of the trade. When might that time come? Who knows. This “illiquid” market would certainly cause us to distrust the markets. 

The ease to enter and exit trades is called liquidity. Providing liquidity is the primary function of all market makers. These market participants buy the bid price and sell the ask price on their specified security for any order that comes their way. 

Of course, market making is no charity – the difference between the bid and the ask is called the spread, and this spread is how market makers make money.

What Are Examples of Option Market Makers?

Let’s jump right into an example to see how market makers help markets run smoothly. 

This example is going to involve a put option on AAPL with three market participants: Jane, Joe and a market maker. 

  • Jane is currently long a AAPL put option contract and wants to sell.

  • Joe wants to buy the same contract Jane is selling.

  • The AAPL put is currently bid for 1.20 and offered for 1.60

Market Making Visualized

market maker options

Both Jane and Joe send a market to both sell and buy, respectively, their put option. These orders are sent to an exchange. Some major exchanges for options include:

  • Chicago Board Options Exchange (CBOE)

  • International Securities Exchange (ISE)

  • NYSE (New York Stock Exchange) Arca

  • Various Nasdaq Markets

After being sent to an exchange, the order is then seen on the screen of a market maker. The market maker buys the put from Jane while simultaneously selling the same put to Joe. 

Since the market maker bought the option at the bid of 1.20 (from Jane) and sold the option for 1.60 (to Joe), the market maker made a profit of 0.40, or $40 taking into account the leveraged multiplier effect of options. Remember, one options contract represents 100 shares of stock. 

Sometimes, Joe and Jane can trade directly together, but the vast majority of the time, a market maker is needed to facilitate these trades. What if there was no other trader out there who was willing to buy that put option Jane wanted to sell? How would she ever get out of her position?

How Do Market Makers Set Option Prices?

Market makers set option prices for all listed derivatives, including equity, ETF, and index options

In the above example, the market for our put option was 1.20/1.60. This means that if you were to buy this option at 1.60 and wanted to sell it immediately, you would have to sell it for 1.20. In other words, you would lose 0.40 (1.60-1.20), or $40, immediately. 

Of course what you lose, the market maker gains. 

But why is this market 1.20/1.60? Is this some arbitrary price? No! 

The width of a market (set by the various market markers for a security) depends on several factors. The more liquid a security is, the easier both you and a market maker can enter and exit positions in that security.

3 Liquidity Measures in Options

Market Makers Liquidity

Before determining the spread of an option (or any security), a market maker considers several liquidity factors. Three of these are:

  1. Volume: How many option contract have been traded so far on any given day.

  2. Open Interest: How many contracts are outstanding in an option.

  3. Bid/Ask Size: How many contracts are bid/offered at that price. 

The higher the volume and the more open interest an option has, the easier a market maker can exit the position they just bought or sold from you. 

Remember, market makers have to exit positions as well! If markets are illiquid, they are going to widen out the spreads to make up for the risks of holding a position in an illiquid market. 

How Market Makers Hedge

Market makers don’t generally turn around and immediately sell an option they bought from you. They’ll have to wait a bit for another trader to come around and give them a good price. So how do they hedge the risk of holding options?

Let’s take a look at an example to find out.

We’ll say AAPL just reported horrible earnings, and every trader out there is trying to sell their call options. A market maker in AAPL must therefore buy these options to fulfill their duty as a liquidity provider. 

This will result in a boatload of long call options for the market maker. That’s a lot of risk! How do market makers offset this risk?

Delta and Gamma Hedging

To mitigate this risk, a market maker keeps an inventory of either long or short stock. How much stock? That depends on their position “delta” and “gamma“.

Δ β θ Read! Introduction To The Option Greeks

For example, if an out-of-the-money call option has a delta of 0.84, that means this contract trades like 84 shares of stock. To offset this risk, a market maker would sell 84 shares of stock.

Sometimes, in volatile markets, a lot of stock must be purchased or sold for a market maker to offset their risk. This can cause stock prices to both soar and tank in value. Market makers hedging their short call options with long stock is the reason many meme stocks soared in value in 2021. This rare market condition is called a gamma squeeze

If you’d like to read more about delta hedging (which both market makers and traders utilize), read our article, Delta Hedging Explained (Visual Guide w/ Examples)

How Do Market Makers Make Money In Payment for Order Flow?

Retail traders are not known for their market savviness. Market makers want retail order flow, particularly in options. Why? The bid/ask spread in options is much wider than in stocks. 

Market makers want this order flow so bad, that they are willing to pay brokers for the right to fill their customer’s orders. 

This is known as payment for order flow. 

Every time you send an order through your broker (unless your broker internalizes their order flow), an auction takes place between your broker and numerous market makers to see who gets to fill your order. 

In these flash auctions, the best bid/offer wins. Payment is sent from the market maker to the broker for filling the order, and the customer is filled.

Market makers do not get paid here – the brokers (like thinkorswim, Robinhood, or tastyworks) do. Market makers make their money in “arbitrage” by trading the products they are specialists for. 

Read: 💲 Payment for Order Flow Explained Simply (w/ Visuals)

Who Are the Largest Options Market Makers?

Although there are many market-making firms, two, in particular, dominate the space: 

  1. Citadel Securities
  2. Virtu

So what percentage of volume do these two firms take from the stock and options markets? The below image, from the Financial Times, shows just how much.

Market makers can be small independent businesses or large hedge funds. In the modern era, hedge funds are taking business from the smaller market makers. You must be very well capitalized to compete in this space!

What Is the Difference Between a Market Maker and a Broker?

With a few rare exceptions, (such as Interactive Brokers), retail brokers do not act as market makers. These two business models provide completely different services. 

  1. Brokers act as intermediaries by facilitating trade orders from both buyers and sellers by bringing together assets.

  2. Market Makers are dealers in securities who provide liquidity to a market by buying and selling that market’s securities at all times. Market makers provide trade execution.

Option Market Makers FAQs

Market makers provide liquidity by both buying and selling options of all types, including call and put options. To offset the risk from selling call options, market makers must purchase stock. This can result in a gamma squeeze. 

In order to adequately mitigate their risk, market makers in options must hedge their positions by either buying or selling shares of stocks. This can lead to fluctuations in the underlying share price, which some believe to be manipulation.

Market makers buy options to satisfy the market. As liquidity providers, the role of the market maker is not limited to buying options – they must stand ready to both buy and sell all options strategies to fulfill their obligation. 

Next Lesson

SPY vs SPYG vs SPYD vs SPYV: Head-To-Head ETF Comparison

In 2022, State Street Corporation currently offers more than 130 ETFs (exchange-traded funds). Generally speaking, ETFs are cheaper and more liquid than mutual funds. 

The most popular of State Street’s ETFs is the SPDR S&P 500 ETF Trust, SPY

The SPY ETF uses the S&P 500 Market Index as its benchmark. SPY is the largest and most liquid exchange-traded product (ETP) in the entire world. 

The popularity of SPY led State Street to create numerous S&P index fund-tracking spinoffs. Some of these funds include:

  • SPYG: SPDR Portfolio S&P 500 Growth ETF

  • SPYD: SPDR Portfolio S&P 500 High Dividend ETF

  • SPYV: SPDR Portfolio S&P 500 Value ETF

  • SDY: SPDR S&P Dividend ETF

  • SPDR: SPDR S&P Biotech ETF

  • SPLG: SPDR Portfolio S&P 500 ETF

In this article, projectfinance will compare the performance and characteristics of four of these funds; SPY, SPYG, SPYD, and SPYV. Let’s look at the takeaways, then get started with a data-table comparison!

              TAKEAWAYS

 

  • State Street’s SPY, SPYG, SPYD ad SPYV all track different variations of the S&P 500 stock market index.

  • SPY is the oldest and most popular straight S&P 500 tracking ETF in the world.

  • SPYG tracks 240 growth stocks within the S&P 500.

  • SPYD tracks only 79 stocks. This ETF has strict criteria for entry, favoring stocks with high dividends.

  • SPYV track 447 stocks in the S&P 500, all of which are high value. This “value” is determined by factors such as book value to price ratio.

  • SPYG experiences the most volatility of all the funds but also has the most upside potential.

  • Though SPYD offers a high dividend, it contains many energy stocks, which are known for their volatility. 
SPY SPYG SPYD SPYV

Fund Issuer:

State Street
State Street
State Street
State Street

Fund Name:

SPDR® S&P 500® ETF Trust
SPDR® Portfolio S&P 500® Growth ETF
SPDR® Portfolio S&P 500® High Dividend ETF
SPDR® Portfolio S&P 500® Value ETF

Fund Category:

Large-Cap Blend
Large-Cap Growth
Large-Cap Value
Large-Cap Value

Underlying Index:

Expense Ratio (fees):

0.09%
0.04%.
0.07%
0.04%

Number of Holdings:

505
240
79
447

1 Year Return:

+15.47%
+18.20%
+18.60%
+12.45%

Morningstar Rating:

☆☆☆☆☆
☆☆☆☆☆
☆☆

Fund Structure:

UIT
(Unit Investment Trust)

ETF
ETF
ETF

Dividend:

(30 Day SEC Yield)

1.27%

0.70%

3.62%

1.93%

What Is the SPY ETF?

  • SPY has a dividend yield of 1.27%

  • The expense ratio (total fees) of SPY is 0.09%

  • State Street’s SPY exchange-traded fund is the first ETF to be issued.

  • SPY tracks the S&P 500 Index.

  • Because of its age (inception date 1993), SPY is structured as a UIT (unit investment trust), though it trades just like an ETF.

  • SPY is currently the most widely traded investment product in the world.

State Street’s SPDR® S&P 500 ETF (Ticker SPY) was the first exchange-traded product in the world to be issued. Here is how State Street describes its fund:

SPY is a straightforward ETF. This low-cost fund tracks the S&P 500 Index (SPX), which is the most followed index in the world. Here are a few quick facts about SPX:

  • The S&P 500 Index contains the 500 largest US companies by market capitalization.

  • The S&P 500 is a float-weighted index, which means larger companies have greater weight than smaller companies.

  • The S&P 500 index is generally considered to be the best gauge for the health of US stocks.

  • The S&P 500 index can not be directly invested in as indices do not offer shares.  

What does the SPY ETF Hold?

The S&P 500 is a well-diversified index containing large-cap stocks from numerous sectors. 

The below image was taken from the factsheet of State Street Global Advisors, the issuer of the SPY ETF:

SPY Sectors

Image from ssga.com

As we can see, information technology accounts for a large segment of the S&P 500 index. Health Care and Consumer Discretionary stocks also have heavyweight in this index, but nowhere as close as tech. 

The IT (tech) sector is dominated by FAANG Stocks, which represent Meta (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Alphabet (GOOGL). 

So what percentage of the SPY ETF is invested in these behemoths? Let’s take a look at the top ten holdings in this fund to find out!

SPY Top Ten Stock Holdings

Image from ssga.com

What Is the SPYG ETF?

  • SPYG has a dividend yield of 0.70%.

  • The expense ratio (total fees) of SPYG is 0.04%.

  • SPYG tracks the S&P 500 Growth Index.

  • Growth stocks have more risk than balanced or value stocks.

State Street’s SPDR® Portfolio S&P 500® Growth ETF (SPYG) tracks only part of the S&P 500 index. Which part? As you can probably guess from its name, this ETF singles out only the growth companies within the S&P 500 Index. 

Growth companies tend to be more volatile than value companies. In bullish markets, growth companies tend to outperform the market while these stocks typically underperform the market in bearish markets. Here is how State Street describes its fund:

So what companies does SPYG track? Let’s look under the hood to find out!

SPYG Sectors

Image from ssga.com

Many information technology stocks fall under the growth sector. Because of this, SPYG has huge exposure to IT stocks – 43.13% to be exact. Compare that to SPY’s IT exposure, which is still lofty at 26.75%. 

So what stocks does SPYG contain? 

As we can see below, SPYG has a lot in common with SPY, with Apple (AAPL), Microsoft Corporation (MSFT) Amazon (AMZN, Tesla Inc. (TSLA), Alphabet Inc. (GOOGL), and NVIDIA (NVDA) all representing the top positions.

However, SPYG places a much greater weight on these IT stocks in relation to SPY. 

SPYG Top Ten Stock Holdings

Image from ssga.com

What Is the SPYD ETF?

  • SPYD has a high dividend yield of 3.62%.

  • The expense ratio (total fees) of SPYD is 0.07%.

  • SPYD tracks the S&P 500 High Dividend Index.

  • High-dividend paying stock tends to be more value-oriented.

State Street’s SPDR Portfolio S&P 500 High Dividend ETF (SPYD) is a great fund for income-thirsty investors. 

This ETF isolates 80 high dividend-yielding companies within the S&P 500 Index. The result is a dividend yield of 3.62%. This yield is higher than SPY’s dividend yield of 1.27% and far surpasses SPYG’s dividend yield of 0.70%.

The downside tradeoff of high dividend-paying stocks usually comes in the form of long-term underperformance. SPYD has vastly underperformed SPY over the past five years, as can be seen below. 

SPY vs SPYD: 5 Year Chart

High dividend-paying companies tend to be less volatile than growth companies. In bullish markets, these companies tend to underperform the market while these stocks typically outperform the market in bearish markets.

Let’s next check out how State Street describes its high dividend-paying fund. 

SPYD Sectors

Image from ssga.com

Our first two ETFs (SPY & SPYG) were dominated by information technology stocks. SPYD, on the other hand, places a relatively minuscule weight on tech equities.

As we can see above, IT stocks account for only 2.45% of SPYD’s weighting. This fund favors utilities, energy, financials, consumer staples, and health care stocks. These stocks tend to be more financially stable, relying on steady income and revenue for steady dividend streams. 

Let’s next see what stocks in particular the SPYD ETF favors. 

SPYD Top Ten Stock Holdings

Image from ssga.com

As we can see, big energy stocks dominate the top ten holdings of SPYD. Let’s take a look at the dividend yields of a few of these companies to see why:

  1. Valero Energy Corporation (VLO): 3.63% Yield

  2. Chevron Corporation (CVX): 3.37% Yield

  3. Sempra Energy (SRE): 2.67%  Yield

What Is the SPYV ETF?

  • SPYV has a dividend yield of 1.96%.

  • The expense ratio (total fees) of SPYV is 0.04%.

  • SPYD tracks the S&P 500 Value Index.

State Street’s SPDR Portfolio S&P 500 Value ETF (SPYV) contains the stocks within the S&P 500 index that are most value forward. A high-value stock is determined by three factors:

  1. Book value to price ratio.

  2. Earnings to price ratio.

  3. Sales to price ratio

Of the 504 the stock in the S&P 500 index (remember that some companies like Google issue two classes of stock – class a and class c), 447 make the cut to be included in this ETF. This is in comparison to SPYD, which only includes 79 stocks. 

High dividend-paying stocks are not synonymous with high-value stocks.

As we will soon learn, SPYV is concentrated in far less volatile stocks than SPYD, with names such as Berkshire Hathaway Inc, Johnson & Johnson, and Procter & Gamble Company topping its holdings.

Let’s do a quick 5-year comparison of SPYD and SPYV, then move on to examine the holdings and top stocks within SPYV. 

SPYD vs SPYV: 5 Year Chart

SPYV Sectors

Image from ssga.com

SPYV Top Ten Stock Holdings

Image from ssga.com

SPY vs SPYG vs SPYD vs SPYV: Performance

Let’s conclude the article by comparing the historical price performance of our four State Street ETFs.

The below two charts compare the three-year and five-year growth of $1,000 invested in our various ETFs. To enlarge the images, simply click on them!

SPY vs SPYG vs SPYD vs SPYV: 3 Year Chart

Image from ssga.com

SPY vs SPYG vs SPYD vs SPYV: 5 Year Chart

Image from ssga.com

SPY vs SPYG vs SPYD vs SPYV: Which is Best?

Every ETF on our list comes with different levels of risk. Generally speaking, SPYG has the most risk and SPYV has the least risk. 

SPY can work for investors of all ages. Its great diversification and high liquidity (its assets under management are over 4B) make this fund very versatile.  

SPYG contains growth stocks, which can be quite volatile during stock market downturns. 

Though SPYD does indeed have a very high dividend, its energy heavy portfolio can prove to be ballast on long-term term returns. 

SPYG is more suitable for younger investors, while SPYD and SPYV are best suited for older investors because of their relative price stability. 

Worth noting here are some of State Street’s competitors: Vanguard’s VOO ETF tracks the S&P 500 as well, but it does so for a lower expense ratio of 0.04%. 

Have a question or comment? Drop a line below and I’ll make sure to reach out to you!

FAQs

SPY track the S&P 500 index. SPYG tracks only the growth companies within the S&P 500 index. The SPYG ETF has 240 stocks within it while the S&P 500 currently has 505. SPYG is more volatile than SPY. 

SPYG, as determined by Morningstar’s 5 star rating, is currently a great investment for investors with a long-term time horizon looking for exposure to large-cap growth stocks. 

Historically, SPYG has significantly outperformed SPY. However, SPYG will most likely underperform SPY in the next bear market. This is because SPYG is comprised of high beta “growth” companies, which are typically in the volatile “Information Technology” sector.

Next Lesson

QQQJ vs QQQM vs QQQN vs QQQE vs QQQ: What’s The Difference?

Comparing Nasdaq ETFs

In 2022, there are a lot of different Nasdaq funds to choose from. In this article, projectfinance will compare five of the more popular ETFs in the tech space: QQQJ, QQQM, QQQN, QQQE and QQQ.

It is important to note that a few of the funds on our list are almost identical (QQQ & QQQM), while others are quite different indeed (QQQJ & QQQE). 

So which fund is best for you? Let’s first break down the data from our 5 ETFs in a table, and then put each one under the microscope!

              TAKEAWAYS

  • The QQQ ETF tracks the Nasdaq 100 Index and is the oldest and most popular fund on our list.

  • QQQM is basically an exact replica of QQQ with lower fees.

  • QQQE tracks the Nasdaq 100 on an “equal weight” basis, which provides better diversification.

  • QQQJ tracks the next 100 stocks in queue for inclusion in the Nasdaq-100 Index.

  • QQQN tracks the next 50 stocks in queue for inclusion in the Nasdaq-100 Index.
QQQJ QQQM QQQN QQQE QQQ

Fund Issuer:

Invesco
Invesco
VictoryShares
Direxion
Invesco

Fund Name:

Fund Category:

Mid-Cap Growth
Large-Cap Growth
Mid-Cap Growth
Large-Cap Growth
Large-Cap Growth

Underlying Index:

Expense Ratio (fees):

0.15%
0.15%.
0.18%
0.35%
0.20%

Number of Holdings:

101
104
49
102
102

1 Year Return:

-7.92%
+14.06%
-8.07%
+4.56%
+14.15%

Morningstar Rating:

Not Rated
Not Rated
Not Rated
☆☆☆☆
☆☆☆☆☆

Fund Inception Date:

10/13/2020
10/13/2020
09/09/2020
03/21/2012
03/10/1999

Fund Structure:

ETF
ETF
ETF
ETF
UIT

What Is the QQQ ETF?

Invesco’s QQQ Exchange-Traded Fund (ETF) is the dinosaur on our list. It was one of the first NASDAQ funds issued and has been active since 1999. The next oldest fund on our list is QQQE, which began 13 years later in 2012.

The Invesco QQQ ETF passively follows the Nasdaq 100 index. 

➥ The Nasdaq 100 Index represents 100 of the largest US and international non-financial companies listed on the Nasdaq Stock Market.

Like most of the funds on our list, QQQ is dominated by big technology companies. The larger of these companies include the “FAANG” stocks – Facebook, Amazon, Apple, Netflix, and Google.

So how have big tech companies fared in the overall market, as indicated by the S&P 500 tracking ETF SPY?

Let’s find out!

QQQ vs SPY: 5 Year Chart

As we can see, QQQ has outperformed SPY considerably over the past 5 years. 

Let’s next take a look under the hood of QQQ by looking at its sector allocation strategy and top holdings. 

QQQ Sector Allocation

Image from Invesco

Ae we can see, Invesco’s QQQ ETF is more than just a tech fund. In addition to information technology companies, its sector allocation spans across multiple sectors and industries. 

But what companies in these sectors does QQQ invest in most? Let’s take a look at the big five next!

QQQ Top Five Holdings

Company Weight

Apple Inc

12.53%

Microsoft Corp

10.22%

Amazon.com Inc

7.32%

Tesla Inc

4.95%

NVIDIA Corp

4.00%

QQQ has huge exposure to AAPL. Why is this? The Nasdaq 100 is a modified capitalization-weighted index. AAPL is the largest company by market capitalization and therefore has the greatest weight. 

Not all ETFs on our list are weighted; QQQE (which we will soon get to) is an equal weight ETF. 

What Is the QQQM ETF?

Invesco’s Nasdaq 100 ETF QQQM has a lot in common with their QQQ fund. The stocks contained within these two funds are mirror images of each other. However, there are two differences worth noting:

QQQ vs QQQM: 2 Differences

  1. QQQ is structured as a UIT (unit investment trust) while QQQM is an ETF.
  2. QQQ charges a fee of 0.20%; QQQM charges a fee of 0.15%

QQQ being structured as a UIT makes no material difference on the performance of the fund when comparing it to QQQM’s performance. 

What should interest you here is the difference in expense ratios. QQQ does indeed charge a higher fee than QQQM. Though the difference is relatively small (0.05%), over time, fees and expenses can really add up.

What we have here, essentially, is two identical funds with one charging a higher expense ratio. QQQM wins every time. 

Read! ETF vs ETP vs ETN vs ETC: What’s the Difference?

QQQM Sector Allocation

Image from Invesco

QQQM Top Five Holdings

Company Weight

Apple Inc

12.53%

Microsoft Corp

10.22%

Amazon.com Inc

7.32%

Tesla Inc

4.95%

NVIDIA Corp

4.00%

What Is the QQQE ETF?

Both QQQ and QQQM track the Nasdaq-100 Index. This index is weighted.

The top 5 stocks in both QQQ and QQQM account for approximately 40% of these funds’ value. That’s not a lot of diversification!

To answer this desire for diversification, the NASDAQ-100 Equal Weighted Index was created. 

In 2012, Direxion created an ETF to track this index: The Direxion NASDAQ-100® Equal Weighted Index Shares (QQQE).

This ETF has equal weighting on all of its holdings. For example, AAPL (which is 12.5% of QQQs holdings) represents 1% of QQQE’s fund. 

Since the smallest company in this index has the same weight as the largest company, it is better diversified. 

However, this diversification comes with a price: QQQE charges a fee of 0.35%, the highest on our list. 

Is the cost justified? Let’s compare QQQ/QQQM with QQQE to find out. 

QQQ/QQQM vs QQQE

Though QQQE is a great alternative to the top-heavy QQQ ETF, its performance has lagged. Why? It places more weight on those smaller companies, which tend to be focused on consumer staples, industries, and utilities. 

Historically, these less volatile stocks underperform the FAANG juggernauts, as shown in the 5-year chart below.

QQQE Sector Allocation

The below chart illustrates the difference between sector allocation in QQQ/QQQM (as represented by XNDX) and the QQQE equal-weighted index (as represented by NETR).

Image from Direxion

QQQE Top 5 Holdings

Every one of the holdings within the QQQE ETF has the same weight of 1%.

Company Weight

Apple Inc

1%

Microsoft Corp

1%

Amazon.com Inc

1%

Tesla Inc

1%

NVIDIA Corp

1%

What Is the QQQJ ETF?

So far, we have only looked at ETFs that track the Nasdaq 100 Index. 

Invesco’s QQQJ Next Gen ETF tracks the NASDAQ Next Generation 100 Index.

These are the companies in the waiting pool to join the Nasdaq 100. There are no mega-cap stocks in this index. QQQJ is mostly comprised of mid-cap stocks. 

Stocks in this index are the less capitalized “up-and-comers” in the tech space. 

Because of this, QQQJ can be more volatile than the other ETFs we have covered in this list. 

QQQJ Sector Allocation

Image from Invesco

QQQJ Top 5 Holdings

Company Weight

Trade Desk Inc/The

2.18%

MongoDB Inc

2.00%

Expedia Group Inc

1.97%

Enphase Energy Inc

1.95%

CoStar Group Inc

1.82%

What Is the QQQN ETF?

Victory Shares Nasdaq Next 50 ETF QQQN tracks the Nasdaq Q-50 index

This ETF is similar to the QQQJ ETF, but QQQN only tracks the next 50 stocks in line to join the Nasdaq 100. 

Let’s do a quick 1-year comparison between QQQJ and QQQN. 

QQQJ vs QQQN: 1 Year Chart

As we can see, the performance of these two ETFs is quite similar. 

It is worth noting that the stocks within QQQN are better capitalized than those that comprise QQQJ. Because of this, QQQN should experience marginally less volatility than QQQJ over time. 

QQQN Sector Allocation

Image from VictoryShares

QQQN Top Five Stocks

Company Weight

BAKER HUGHES CO

3.46%

GLOBALFOUNDRIES INC

3.09%

TRADE DESK INC

2.97%

MONGODB INC

2.80%

ENPHASE ENERGY INC

2.72%

QQQJ vs QQQM vs QQQN vs QQQE vs QQQ: What's The Best?

A lot of the funds on our list are relatively new, so it is impossible to compare their long-term performance. 

  • QQQ, QQQM, and QQQE all track the Nasdaq 100 index.

  • QQQJ and QQQN track the more growth-centric companies just outside of the Nasdaq 100.

  • A well-diversified portfolio will have exposure to as many stocks as possible, including those within the Nasdaq 100 as well as those on the cusp of joining the index.

FAQs: QQQJ vs QQQM vs QQQN vs QQQE vs QQQ

QQQ is structured as a unit investment trust (UIT) while QQQM is structured as an ETF. Though their performance is identical, QQQM charges a lower expense ratio of 0.15% as compared to the QQQ fee of 0.20%

QQQ invests tracks the Nasdaq 100 index while QQQJ tracks Nasdaq Next Generation 100 Index (Index). This latter index invest in the 101st to the 200th largest companies on the NASDAQ.

Historically, QQQE has underperformed QQQ. QQQE’s equal weight structure applies more allocation to companies outside of tech, such as consumer staples and utilities. These sectors generally underperform in bull markets. 

Next Lesson

What is UVIX? (2x Long Volatility ETF Explained)

Volatility has become a tradable asset class due to the success of volatility ETPs such as VXX, SVXY, and UVXY.

UVIX is one of the newest products entering the volatility trading space, restoring the 2x leveraged long volatility exposure that UVXY once had.

What is UVIX and How Does it Work?

The Long VIX Futures ETF (Ticker: UVIX) seeks to provide daily investment results, before fees and expenses, that correspond to 2x the Long VIX Futures Index (Ticker: LONGVOL).

The inception date of UVIX is scheduled to be March 30th, 2022. Volatility Shares is the issuer of UVIX.

Let’s explore the Long VIX Futures Index mentioned in the product description to learn how UVIX works.

What is the Long VIX Futures Index (LONGVOL)?

The benchmark UVIX tracks is the Long VIX Futures Index (LONGVOL) by Cboe.

Index Methodology: LONGVOL tracks the daily performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily. The portfolio aims to hold a mixture of the two futures to achieve a weighted average of 30 days to settlement.

If it is February 1st, the first-month VIX future will be the February contract, and the second-month VIX future will be the March contract.

VIX futures track the Cboe Volatility Index (the VIX Index), which increases during times of heightened market volatility and falls during calm market periods.

A long VIX futures position profits when the:

  • VIX index increases to higher levels, pulling VIX futures contracts up along with it.

  • VIX futures curve is in backwardation, causing short-term futures to drift higher as they converge towards the higher VIX index.

The LONGVOL index will therefore increase during rising or persistently high volatility market conditions where VIX futures are in backwardation.

Bullish UVIX traders are effectively long Cboe volatility index futures.

Bearish UVIX traders are effectively short Cboe volatility index futures.

LONGVOL Movement Examples

The past performance of the LONGVOL index informs us about how UVIX should perform under various market conditions:

During extended periods of low volatility, UVIX will lose substantial value driven by consistent contango in the VIX futures market, leading to decaying near-term VIX Futures.

VIX Contango: The Ultimate Beginner’s Guide

Consequently, the share price of UVIX will decay immensely, as LONGVOL did during the persistently low volatility of 2016. Here is LONGVOL during the first few months of 2016:

From February 2016 to June 2016, LONGVOL fell from 7,600 to around 3,600, a decrease of over 50%. UVIX would have experienced an even worse decline, as it tracks 2x the daily percentage change of LONGVOL.

But during periods of surging market volatility, UVIX will gain significant value. The faster the increase in volatility, the larger the increase UVIX will experience.

Here’s what LONGVOL did in early 2020:

Source: Cboe

If you’re familiar with UVXY, it used to have 2x long volatility exposure like UVIX. After the “volmageddon” of 2018, UVXY’s leverage was reduced from 2x to 1.5x.

UVIX is the new 2x long volatility product, restoring the previously accessible 2x leverage to the long volatility product space.

While UVIX may experience exponential returns during periods of rapidly increasing or persistently high volatility, the long-term trend in UVIX will be down as VIX futures are in contango a majority of the time during normal market conditions.

What is the Difference Between VIX and UVIX?

The VIX cannot be traded directly. UVIX allows positive leveraged exposure to changes in the VIX index through the VIX futures market.

The Cboe VIX Index is a calculation of market implied volatility using S&P 500 Index options with around 30 days to expiration.

The VIX index cannot be traded as there are no underlying shares. It is only a calculation.

To trade anticipated changes in the VIX index, traders turn to VIX futures and options.

Trading VIX futures is a risky endeavor, as one VIX futures contract represents $1,000 per point in notional value (a large position). A 10-point move in a VIX futures position translates to a P/L of $10,000 on one contract.

UVIX is an ETF that tracks the LONGVOL index, which tracks 2x the single-day percentage changes of the first and second-month VIX futures contracts.

For instance, if it is February 1st, LONGVOL will track 2x the single-day percentage changes of a mixed portfolio of February and March VIX futures contracts.

UVIX is a volatility product that allows traders to gain leveraged exposure to changes in the VIX index through the futures market.

VIX Index <= VIX Futures <= UVIX

What is the Difference Between UVIX and SVIX?

UVIX, the 2x Long VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to twice the performance of the Long VIX Futures Index (LONGVOL).

UVIX is a 2x leveraged long volatility product.

UVIX aims to return 2x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

SVIX, the Short VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to the performance of the Short VIX Futures Index (SHORTVOL).

SVIX is a short volatility product.

SVIX aims to return -1x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

Read our full guide on SVIX.

How Risky is UVIX?

UVIX is a high-risk leveraged volatility product.

UVIX should not be held as a long-term “investment.” Buying shares of UVIX does not represent ownership of any business, unlike buying shares of SPY.

During calm market periods where the VIX futures are in contango, UVIX will lose value steadily from the decaying VIX futures.

The investment strategy of holding UVIX during low market volatility with the anticipation of increasing market volatility is not easy.

In the event of a short-term volatility spike, UVIX can gain significant value, but over time, it should trend towards zero.

UVIX is designed for short-term stock and options trading, not long-term “investing.” It is incredibly expensive to hold long volatility positions constantly, as VIX futures lose value when in prolonged periods of contango.

Additionally, the complex nature of UVIX can cause uninformed traders to lose money due to a lack of understanding of the product’s mechanics.

I do not recommend making any trades in UVIX unless confident in your understanding of how it works, and the risks of your specific trades.

How is UVIX Calculated?

UVIX is benchmarked to the Long VIX Futures Index (LONGVOL).

LONGVOL tracks the daily performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily.

Each day, the net asset value (NAV) of UVIX should correspond to:

Previous Closing Price + 2x the Current Trading Day’s LONGVOL Change (%)

Example: UVIX closes at $50 on Monday.

On Tuesday, if the LONGVOL index increases by 3%, UVIX shares should trade 6% higher at $53 ($50 x 1.06).

Conversely, if the LONGVOL index falls by 10%, UVIX shares should fall 20% to $40 ($50 x 0.80).

The above examples represent no tracking error (perfect tracking of index performance). In reality, exchange-traded products can experience tracking error.

Source: UVIX Prospectus (p.36)

Is There Options Trading on UVIX?

UVIX is a brand new product (inception date of March 30th, 2022) and does not yet have a liquid options market. Time will tell if the options market in UVIX improves.

Does UVIX Pay a Dividend?

No, UVIX does not pay a dividend.

Additional Resources

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What is SVIX? (Short Volatility ETF Explained)

Volatility has become a tradable asset class due to the success of volatility ETPs such as VXX, SVXY, and UVXY.

SVIX is one of the newest products entering the volatility trading space.

What is SVIX and How Does it Work?

The -1x Short VIX Futures ETF (Ticker: SVIX) seeks to provide daily investment results, before fees and expenses, that correspond to the Short VIX Futures Index (Ticker: SHORTVOL).

The inception date of SVIX is scheduled to be March 30th, 2022. Volatility Shares is the issuer of SVIX.

Let’s explore the Short VIX Futures Index mentioned in the product description to learn how SVIX works.

What is the Short VIX Futures Index (SHORTVOL)?

The benchmark SVIX tracks is the Short VIX Futures Index (SHORTVOL) by Cboe.

Index Methodology: SHORTVOL tracks the daily inverse performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily. The portfolio aims to hold a mixture of the two futures to achieve a weighted average of 30 days to settlement.

If it is February 1st, the first-month VIX future will be the February contract, and the second-month VIX future will be the March contract.

VIX futures track the Cboe Volatility Index (the VIX Index), which increases during times of heightened market volatility and falls during calm market periods.

A short VIX futures position profits when the:

  • VIX index falls to lower levels, pulling VIX futures contracts lower with it.

  • VIX futures curve is in contango, causing short-term futures to trade lower as they converge towards the lower VIX index (contango bleed).

The SHORTVOL index will therefore increase during falling or persistently low volatility market conditions.

Bullish SVIX traders are effectively short Cboe volatility index futures.

Bearish SVIX traders are effectively long Cboe volatility index futures.

SHORTVOL Movement Examples

The past performance of the SHORTVOL index informs us about how SVIX should perform under various market conditions:

During extended periods of low volatility, SVIX can increase exponentially as it captures continuous positive daily percentage returns from the decaying VIX futures.

Consequently, the share price of SVIX can compound, as SHORTVOL did during the persistently low volatility of 2016 and 2017:

From January 2016 to January 2018, SHORTVOL went from the low 300s to 2,800, an increase of 833%. SVIX would have experienced a similar return.

But during periods of surging market volatility, SVIX will likely lose substantial value. The faster the increase in volatility, the larger the drawdown SVIX will experience.

In early 2018, the popular short volatility ETF, SVXY, lost over 90% of its value after market volatility spiked:

Source: Google Finance

The short volatility product XIV was terminated following the collapse. SVXY’s leverage was reduced from -1x to -0.5x.

SVIX is the new -1x volatility product, restoring the previously accessible -1x leverage to the short volatility product space.

While SVIX may experience exponential returns during prolonged periods of low volatility, all of its value can be lost in the event of a massive short-term spike in volatility.

What is the Difference Between VIX and SVIX?

The VIX cannot be traded directly. SVIX allows inverse exposure to changes in the VIX index through the VIX futures market.

The Cboe VIX Index is a calculation of market implied volatility using S&P 500 Index options with around 30 days to expiration.

The VIX index cannot be traded as there are no underlying shares. It is only a calculation.

To trade anticipated changes in the VIX index, traders turn to VIX futures and options.

Trading VIX futures is a risky endeavor, as one VIX futures contract represents $1,000 per point in notional value (a large position). A 10-point move in a VIX futures position translates to a P/L of $10,000 on one contract.

SVIX is an ETF that tracks the SHORTVOL index, which tracks -1x the single-day percentage changes of the first and second-month VIX futures contracts.

For instance, if it is February 1st, SHORTVOL will track -1x the single-day percentage changes of a mixed portfolio of February and March VIX futures contracts.

SVIX is a volatility product that allows traders to gain exposure to changes in the VIX index through the futures market.

VIX Index <= VIX Futures <= SVIX

What is the Difference Between UVIX and SVIX?

UVIX, the 2x Long VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to twice the performance of the Long VIX Futures Index (LONGVOL).

UVIX is a 2x leveraged long volatility product.

UVIX aims to return 2x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

Read our full guide on UVIX.

SVIX, the Short VIX Futures ETF, seeks to provide daily investment returns, before fees and expenses, that correspond to the performance of the Short VIX Futures Index (SHORTVOL).

SVIX is a short volatility product.

SVIX aims to return -1x the daily percentage change of a portfolio consisting of first and second-month VIX futures contracts.

How Risky is SVIX?

SVIX is a high-risk volatility product.

SVIX should not be held as a long-term “investment.” Buying shares of SVIX does not represent ownership of any business, unlike buying shares of SPY.

During calm market periods where the VIX futures are in contango, SVIX will gain value steadily.

The investment strategy of holding SVIX shares during low market volatility can produce incredible returns, but not without the risk of catastrophe.

In the event of a short-term volatility spike, SVIX can lose all or most of its value, as XIV and SVXY did during the “volmageddon” in 2018.

SVIX is designed for short-term stock and options trading, not long-term investing.

Additionally, the complex nature of SVIX can cause uninformed traders to lose money due to a lack of understanding of the product’s mechanics.

I do not recommend making any trades in SVIX unless confident in your understanding of how it works, and the risks of your specific trades.

How is SVIX Calculated?

SVIX is benchmarked to the Short VIX Futures Index (SHORTVOL).

SHORTVOL tracks the daily inverse performance of a theoretical portfolio of first and second-month VIX futures contracts that are rolled daily.

Each day, the net asset value (NAV) of SVIX should correspond to:

Previous Closing Price + Current Trading Day’s SHORTVOL Change (%)

Example: SVIX closes at $50 on Monday.

On Tuesday, if the SHORTVOL index increases by 3%, SVIX shares should trade at $51.50 ($50 x 1.03).

Conversely, if the SHORTVOL index falls by 10%, SVIX shares should fall to $45 ($50 x 0.90).

The above examples represent no tracking error (perfect tracking of index performance). In reality, exchange-traded products can experience tracking error.

Source: SVIX Prospectus (p.36)

Is There Options Trading on SVIX?

SVIX is a brand new product (inception date of March 30th, 2022) and does not yet have a liquid options market. Time will tell if the options market in SVIX improves.

Does SVIX Pay a Dividend?

No, SVIX does not pay a dividend.

Additional Resources

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Money 101: The Functions & Characteristics of Money

Money is at the core of almost everything we do.

Unless you live in the wild and fully support yourself, you use money.

In this guide, you will deepen your understanding of money by exploring the:

  • Functions of money
  • Characteristics of money
  • Evolution of money

Let’s begin!

What is Money?

According to the Merriam-Webster definition, money is generally accepted as a medium of exchange, a measure of value, or a means of payment.

So “money” is:

– Recognized by society as being an acceptable form of payment for things

– People can value goods/services in terms of money

The combination of these things means:

#1: I can walk into a U.S. grocery store and buy food with U.S. dollars, the recognized and acceptable form of currency in the United States.

#2: I can assess how valuable things are by comparing their values in a common unit of measurement (if a bottle of wine is $20, and a car is $20,000, I know the car is more valuable than the bottle of wine).

But it wasn’t always like this.

Thousands of years ago, the barter system (trading goods for goods) was the primary method of exchange.

If I made pots and you made blankets, I could trade you a pot for a blanket:

Goods/Services ⇒ Goods/Services

The barter system is inefficient because of the double coincidence of wants. For a trade to happen, each person must want what the other has to offer.

This is where modern money came to save the day.

By having a common thing that society recognizes, values, and demands, trade can occur between two parties even if they don’t want the goods/services the other has to offer.

We call the collectively recognized and valued thing money.

What Does Money Really Represent?

One of the most profound things I’ve come to understand about money is it is effectively stored energy.

Money we earn represents our life/labor energy.

We spend time and energy working to earn money to spend, save, or invest.

We convert our time and energy into money that we can later convert into a good or service.

Time and Energy Spent Working ⇒ Money ⇒ Goods/Services

Throughout history, money has taken many forms: shells, salt, sticks, stones, coins, paper, and now, digital money like digital USD and bitcoin.

The specific types of money have evolved over thousands of years as better forms of money emerged.

What makes a form of money better than another? We will explore that shortly.

The 3 Functions of Money

Regardless of the form of money (gold coins, paper notes, bitcoin) there are three primary functions of money:

  • Medium of Exchange

  • Store of Value

  • Unit of Account

Let’s explore each of these money functions with examples.

Medium of Exchange

The first function of money is a medium of exchange, or a common item that people use to carry out transactions.

Example: I go out to dinner and pay the restaurant U.S. dollars (USD) for my food.

Money (USD) ⇒ Dinner

The restaurant takes my dollars and pays their suppliers for ingredients and staff for serving me.

Money (USD) ⇒ Restaurant Supplies + Payroll

The staff takes their dollars and exchanges them for food, clothes, and shelter.

Money (USD) ⇒ Food, Clothes, and Shelter

Having a medium of exchange makes trade much more efficient because I can pay someone money for goods/services, which they accept because they know someone else will accept that same money for goods/services (money has constant demand).

If the people in a society all recognize and value a common medium of exchange, those people pay and receive payment in that medium of exchange.

In the United States, the recognized medium of exchange is the U.S. Dollar (USD).

In the eurozone, the recognized medium of exchange is the euro.

In El Salvador, the recognized mediums of exchange are USD and bitcoin.

Store of Value

The second function of money is serving as a store of value (preserving value across time).

The benefit of having a store of value is that we don’t have to spend our money immediately if we have no wants or needs.

With no immediate wants or needs, we can save or invest our money to spend it in the future by holding it in a store of value.

Without a store of value, we have to spend our money immediately, even if we don’t have anything we need to buy. Without a store of value, we increase wasteful spending and can’t save for the future.

Ideally, money serves as a store of value by preserving purchasing power over time. As we’ll see in a later section, this hasn’t been the case for modern money over long time periods.

What Makes a Good Store of Value?

A good store of value will preserve (or grow) purchasing power over time.

Purchasing power is how much stuff I can buy with my money.

If $100 in my bank can buy 100 widgets today and 100 widgets a year from now, the money holds its purchasing power and is a fantastic store of value.

Stable/Growing Purchasing Power Over Time ⇒ Great Store of Value

If $100 in my bank can buy 100 widgets today but only 50 widgets a year from now, the money loses purchasing power and is not a store of value.

Loss of Purchasing Power Over Time ⇒ Bad Store of Value

The store of value function is critical to the success of a form of money.

If a money does not hold its purchasing power over time, its users are encouraged to spend their money sooner than later because they will be able to buy less in the future compared to now. Rapid loss of purchasing power prevents people from saving money for future consumption.

Additionally, those selling goods/services may be hesitant to accept something that doesn’t hold its purchasing power over time.

For instance, if I I’m selling a $1,000 item, I’ll be hesitant to accept $1,000 worth of bananas instead of $1,000 in gold.

The bananas will perish within a week and render the entire sale worthless.

The gold doesn’t spoil, and I can hold it comfortably for an extended period of time. It may even appreciate!

Unit of Account

The third function of money is acting as a unit of account (common measure of value).

With a common unit of measurement, we can easily track changes in wealth and compare the prices of goods/services.

If a cup of coffee is $5 and a bottle of wine is $100, I know the bottle of wine is more valuable than the coffee.

But if the coffee is $5 and the bottle of wine is 100 shells, it’s not clear which item is more valuable because the measure of value is different.

This is why it’s confusing traveling to foreign countries: they have a different unit of account than you’re used to, making it hard to understand the value of things. Is 10,000 yen a lot of money? How much are 25 pesos worth in USD? Confusing!

We’ve now explored how money serves as a:

  • Medium of exchange
  • Store of value
  • Unit of account

Technically, anything can be money, so what explains why money has changed forms so many times over the millennia?

The 8 Characteristics of Money

A new form of money should be graded on a basket of characteristics.

Something with high grades in all money characteristics is a better form of money than something with high scores in only a few of the characteristics.

The market will ultimately choose the best form of money—the one with the highest cumulative ranking in all characteristics of money.

What are these characteristics?

Durable

Money that is durable (difficult to destroy) is safer to possess than fragile money. Durability exists in a physical and digital sense.

Wine glasses would be a poor form of money because they are fragile. If your wealth is stored in wine glasses and a bulldozer drives over them, you’re toast.

Gold is virtually indestructible (A+ durability), which is one reason it has stood the test of time as a widely recognized store of value.

If your house was burning down, it would be better to have bars of gold under your mattress as opposed to piles of dollar bills.

Gold is, therefore, more durable than paper money.

Durability exists in a digital sense too.

For example, bitcoin has no physical form, but it is incredibly durable. So how can digital money be durable?

Bitcoin is entirely digital money requiring the entire history of transactions to keep track of who owns what.  If the entire bitcoin ledger (transaction history) was stored on a single computer, the wealth of every user could be erased by destroying the computer storing the ledger (no history of transactions = no way to verify ownership).

Fortunately, the bitcoin ledger is stored and updated on a global computer network consisting of tens of thousands of computers.

Simultaneously destroying every computer storing bitcoin’s transaction history is virtually impossible, making bitcoin highly durable.

Fungible

Money needs to be fungible, or interchangeable with other identical units without loss of value.

Government-issued currencies are highly fungible because it doesn’t matter which $1 bill you have.

If I have $1 and you have $1, we can exchange the notes and be in equal standing.

When gold and silver coins were used as currency, fungibility would be a problem in a scenario where my gold coin was 95% pure while your gold coin was 90% pure. I wouldn’t want to give you my 95% gold coin for your 90% gold coin, even if they were marked the same and supposed to be of equal value.

Even if the coins were marked similarly and said to be equal, they wouldn’t be fungible because of the differing purities. Additionally, early forms of precious metal coins likely differed in shape and size, decreasing fungibility.

If various “identical” units of money are deemed more valuable than others, the money becomes less acceptable than a fully fungible form of money and will not move as freely through the economy.

Divisible

Money that is highly divisible allows for accurate payments of any value.

Without divisibility:

  • Value is lost through inaccurate exchanges.

  • Small exchanges don’t happen at all

For instance, if our minimum denomination was $5, I could not accurately pay for something worth $7. I’d have to pay $10 and overpay by $3 or the merchant would have to accept $5 and lose $2.

U.S. currency is divisible because each $1 consists of 100 units called pennies.

Bitcoin is divisible because each unit is divisible into 100 million units called satoshis (sats).

It doesn’t matter if a good is worth $1.23 or 0.0003 BTC, I can pay the exact amount because U.S. dollars and bitcoin are highly divisible.

Portable

Money must be portable so that it can move around easily.

A gold bar is not very portable because it’s big and heavy. Not to mention it’s not very divisible either! Therefore, a gold bar is not great day-to-day money.

The introduction of paper currencies convertible to gold made money more portable because paper is light and flexible. It’s easier to carry around a piece of paper that represents $100 in gold than $100 in physical gold.

Today, money is more portable than ever because it is mostly digital.

Portability doesn’t only involve moving money physically, but how easily it can move across borders.

Digital USD is portable within the USA, but less so internationally. There are restrictions on where I can send USD in the world, and it may take days.

Bitcoin is digital and borderless. BTC can be sent anywhere in the world without permission from financial gatekeepers.

Therefore, digital USD is highly portable within the USA but is less portable than BTC in terms of sending global payments.

Verifiable

Money must be verifiable to become counterfeit-resistant.

If the authenticity of money cannot be verified, the potential for counterfeit increases.

Government-issued currencies are verifiable from the serial numbers and intricate markings that appear on each unit of currency, providing them with strong counterfeit-resistance.

Bitcoin cannot be spent without access to the private key associated with a bitcoin wallet. Bitcoin’s ledger, or history of transactions, is public, making it easy to verify any transaction.

Scarce

Scarcity is a critical characteristic of money because it is essential to the value of money over long periods of time. Everything that is valuable is scarce.

Your life is valuable because it has a time limit.

The Flying Fox yacht is valuable because there are few 450-foot luxury yachts in the world.

Gold is scarce because we must go through the time-intensive and costly process of digging it out of the ground.

Scarcity is essential to the preservation of value over time.

Limited supply and/or costly production improve scarcity.

Resistant to Confiscation and Censorship

Lastly, money should be resistant to confiscation (theft) and censorship (control of how money is used).

If a money is easy to confiscate, people are not safe storing their wealth in it.

After all, money represents our blood, sweat, and tears. If our money is confiscated, our life energy is stolen. Similarly, if our payments can be censored, we aren’t free to spend our money how we’d like to.

Different forms of the same money can be more or less resistant to confiscation and censorship.

For example, physical dollars can easily be stolen by a thief, which is why most people store their money at commercial banks and access it digitally.

Physical money is censorship-resistant because only the carrier of physical money can choose how it is spent/moved.

Digital dollars are much harder to steal, but are much less resistant to censorship (a bank can reject a credit card payment or wire transfer).

The Acceptability of Money

The characteristics of money make it more acceptable.

Money is the most “salable” good in an economy, or the easiest to sell.

Why? Everyone wants money because they can use it for anything.

Since money is highly demanded, it’s easy to sell (which is what you do when you buy something).

A money ranking high in all money characteristics will be more demanded than a money ranking poorly in the money characteristics.

Example: a form of money that is durable, scarce, divisible, portable, and verifiable will be more salable/demanded/acceptable than money that has low rankings in these characteristics.

Commodity Money vs. Representative Money vs. Fiat Money

Money has evolved over many thousands of years.

In the past, commodity money was the norm, which is money that derives value from its material, such as gold and silver coins.

Commodity money like gold and silver coins have intrinsic value because gold and silver are valuable.

Commodity money is inherently lacking in portability, verifiability, and fungibility. It’s inefficient to carry around a pouch of precious metals (not portable), they can be counterfeited (difficult to verify) and come in varying shapes and sizes (not fungible).

To improve the characteristics of commodity money, the world introduced representative money, which is money that is backed by something, such as gold.

An example of representative money would be a currency note convertible to a specified amount of gold.

Instead of carrying around gold coins, people could carry around paper notes representing convertibility to gold coins, increasing portability, verifiability, and fungibility.

Paper notes convertible to gold was the case under the gold standard.

Eventually, fiat money became the global standard, which is money that derives its value from government order.

A $20 bill (USD) is an example of fiat money. It has no intrinsic value because it’s only a piece of paper. But a $20 bill is valuable because the government says it has value, and it is legally recognized as currency in the United States, providing it with constant demand.

What is Legal Tender?

An emerging form of money may have high ranks in the characteristics of money, but that doesn’t mean it will be immediately and widely recognized as money.

Legal tender is a form of money that is legally recognized as an acceptable form of payment in a country.

 
However, individuals and businesses can choose to accept forms of money that are not designated as legal tender.

The U.S. dollar is legal tender in the United States, while the peso is legal tender in Mexico.

In September 2021, El Salvador became the first country in the world to begin recognizing bitcoin as legal tender, making it a widely accepted currency in the country.

The Problems With Fiat Currencies

While fiat money such as the U.S. dollar ranks well on many of the characteristics of money, it falls short in the scarcity category. And, centrally-controlled monies can be censored, cutting out users from the financial system.

Fiat currencies do not have limited supply because governments control their country’s monetary policy, or how the money supply of their currency is managed.

The Federal Reserve is the institution that controls the monetary policy in the United States.

Centralized control of monetary policy allows for quick action in regards to the money supply, but not without consequences.

Central banks can create more units of currency instantly and without cost, like changing a number in a spreadsheet.

If the supply of money rises quickly, each unit of currency is susceptible to loss of purchasing power (more units required to buy the same amount of goods and services).

Currencies can lose purchasing power rapidly in the case of severe mismanagement of a nation’s currency.

Over time, the U.S. dollar has lost purchasing power. The longer the time period, the greater the loss of purchasing power.

Here’s a graph from the U.S. Bureau of Labor Statistics of the purchasing power of the U.S. dollar since 1913:

While there have been periods of increasing purchasing power, the long-term trend is down.

According to Visual Capitalist, $1 in 1913 could buy 30 Hershey’s chocolate bars, but only one McDonald’s coffee in 2020:

To provide more context, according to usinflationcalculator.com, $1,000 in 1913 had the same purchasing power as $28,658 in 2022:

In other words, if you held $1,000 in a bank account during that period and didn’t grow it, your $1,000 in 2022 is nearly worthless compared to what it could buy in 1913.

You needed to grow each dollar 28x to maintain purchasing power since 1913. Any returns lower than a 28x resulted in lower purchasing power.

We can compare the purchasing power loss of the U.S. dollar to the US money supply since the late 1950s:

Source: Trading Economics

The U.S. dollar has lost almost all purchasing power since the early 1900s as the Federal Reserve printed more of them.

Some economists argue that an increase in the money supply doesn’t cause inflation.

As I write this, the Federal Reserve is printing money (increasing the money supply) faster than ever before, and CPI inflation is at 7.9% year-over-year (as of Feb 2022), the highest in 40 years.

Other countries have experienced hyperinflation, which is essentially a currency failure because prices are rising so fast (higher prices = lower purchasing power).

The Zimbabwe dollar is one example of a currency that became worthless due to hyperinflation, which isn’t surprising when we look at the changes in the money supply:

Source: Trading Economics

The conclusion is that fiat currencies are not long-term stores of value. Historically, long-term holding periods of fiat currencies has led to significant loss of purchasing power.

While fiat money is efficient for short-term saving and spending (and required for payment of federal taxes) investors seeking to preserve/grow their purchasing power over time need to allocate money to other financial assets such as stocks, real estate, precious metals, or bitcoin.

Conclusion

Money serves a critical role in modern economies:

1) It serves as a medium of exchange, allowing for more trade to occur by removing the double coincidence of wants (two parties simultaneously wanting the good or service the other has to offer).

2) It serves as a unit of account or common measure of value, allowing for societies to easily understand the relative costs of things and keep track of changes in financial accounts.

3) It serves as a store of value, allowing us to preserve purchasing power (though not over long periods of time in the case of fiat currencies) and not spend all of our earnings immediately.

But not all forms of money are good.

The best forms of money rank high on a list of characteristics: durability, fungibility, divisibility, portability, verifiability, scarcity, and resistance to both confiscation and censorship.

Over the millennia, money has evolved and taken many different forms, each time advancing to a new form of money with better overall rankings in monetary characteristics.

Fiat currencies are the current global standard, as they rank high in most monetary characteristics.

Unfortunately, the history of fiat currencies shows that they fail as a store of value over time due to their unlimited supply and zero cost of creation, deteriorating the wealth of those confined to them.

Additionally, users of centrally-controlled currencies are subject to the mismanagement of the money supply and financial censorship.

Will the emergence of digital money like bitcoin, following rules of code that aren’t controlled by a central authority, be the next global standard for money?

Or will we remain on a fiat standard for centuries to come?

Time will tell.

One thing is likely: money will continue evolving over time as superior forms of money come into existence.

I truly enjoyed putting this piece together, and I hope it was insightful and succeeded in deepening your understanding of money.

Chris Butler portrait

VXX Alternatives: UVXY vs VIXY vs VIXM vs VXZ vs SVXY vs UVIX vs SVUX

In March 2022, Barclays suspended sales of its wildly popular iPath Series B S&P 500 VIX Short-Term Futures ETN, better known as VXX

Though it will be hard in the short term for competitive ETFs (and ETNs) to match VXXs liquidity, there are indeed alternatives to Barclay’s VXX ETF.

All market volatility products in this article come with significant risks. To learn more about these risks, read this alert from the SEC.

Let’s fly over a few of the different futures-based volatility ETFs investors have before analyzing and comparing them individually. 

  1. UVXY: ProShares Ultra VIX Short-Term Futures ETF

  2. VIXY: ProShares VIX Short-Term Futures ETF

  3. VIXM: ProShares VIX Mid-Term Futures ETF

  4. VXZ: iPath Series B S&P 500® VIX Mid-Term Futures ETN

  5. SVXY: ProShares Short VIX Short-Term Futures ETF

UVXY vs VIXY vs VIXM vs VXZ vs SVXY

UVXY VIXY VIXM VXZ SVXY

Fund Name:

ProShares Ultra VIX Short-Term Futures ETF

ProShares VIX Short-Term Futures ETF

ProShares VIX Mid-Term Futures ETF

iPath Series B S&P 500 VIX Mid-Term Futures ETN

ProShares Short VIX Short-Term Futures ETF

Market Direction:

Long

Long

Long

Long

Short

Leverage Ratio:

1.5X Leverage

1x Leverage

1x Leverage

1x Leverage

.5x Leverage

VIX Duration Structure:

Short-Term Futures

Short-Term Futures

Mid-Term Futures

Mid-Term Futures

Short-Term Futures

Average Volume:

82,945,752

9,124,628

146,211

56,690

5,823,345

AUM (Assets Under Management):

$840.39M

$363.87M

$108.19M

$65.58M

$425.01M

Expense Ratio:

0.95%

0.85%

0.85%

0.89%

0.95%

How does the UVXY ETF work?

  • ProShares UVXY ETF (exchange-traded fund) rises in value with increases in the expected volatility of the S&P 500 as measured by VIX futures; UVXY does NOT track the VIX (aka “fear index”) directly.


  • UVXY tracks the return of numerous VIX futures with a weighted average time until expiration of one month.


  • UVXY seeks a leveraged return 1.5x the return of the short-term VIX futures index it tracks on a daily basis.

  • Due to the compounding of returns, positon’s held in UVXY for more than a single day can deviate greatly from the benchmark.


  • “Roll Yield” contributes to UVXY’s profound decay.

Out of all the funds on our list, UVXY is the most liquid. With an average of 83 million shares traded every day, traders should have little slippage entering and exiting positions. Also worth noting is the funds very high expense ratio of 0.95%!

Like most funds on our list, ProShares UVXY ETF tracks the S&P 500 Short-Term VIX Futures Index. Let’s first see how ProShares describes their fund in the ETFs prospectus:

 

Since VIX Futures expire regularly, short-term futures ETFs must contain more than one contract to provide their average one to expiration ideal holdings. Let’s see what’s under the hood next.

UVXY Holdings and Performance

The below image, taken from ProShares’ prospectus of UVXY, shows the funds current holding:

We can see that UVXY currently has a larger position in VIX April futures than VIX May futures (far right side of the above image). As time advances, and the April expiration approaches, the position will be increasingly rolled out to May. 

UVXY is the only leveraged ETF on our list. What the fund does not list in its holdings are the securities they utilize to achieve this leverage. 

However, we can read in the prospectus that ProShares implements derivatives, such as “swaps”, to achieve this leverage. 

Due to the nature of both swaps and contango, UVXY perpetually sheds value, as can be seen in the below one-year performance chart. 

Want to learn how Contango works? Check out our article on Contango written by Chris Butler!

UVXY One Year Chart

If you’d like an in-depth review of UVXY, please check out our article, “UVXY: What Is It and Is It Worth The Risk?

How does the VIXY ETF work?

  • ProShares VIX Short-Term Futures ETF (VIXY) rises in value with increases in the expected volatility of the S&P 500 measured by VIX futures contracts.

  • VIXY is NOT a leveraged ETF but aims for a 1x return of its benchmark, the VIX Short-Term Futures Index VIX.

  • Like UVXY, VIXY uses futures with a weighted average of one month to expiration.

  • Like UVXY, VIXY is intended for short-term use; over a period of more than one day, the ETF often fails to track the index adequately because of contango.

VIXY has a lot in common with UVXY, with three notable exceptions:

UVXY vs VIXY: 3 Differences

  1. Unlike UVXY, VIXY is not a leveraged product, and decays less over time because of this. 

  2. VIXY is less liquid than UVXY.

  3. VIXY charges a fee of 0.85%, which is less than UVXY’s fee of 0.95%.

If you understand UVXY, you should have a pretty good idea of how VIXY works. The only difference is this fund is not leveraged. Let’s take a quick look at how ProShares describes their fund, then move on to the holdings and performance of UVXY.

 

VIXY Holdings and Performance

The below image, taken from ProShares’ prospectus of VIXY, shows the funds current holding:

ProShares VIX short-term futures ETF (VIXY) is very similar in nature to UVXY.

We can see they are currently invested in both April and May VIX futures. The proportion of these two months is also nearly the same. VIXY, however, has a lesser quantity of VIX futures than UVXY. Why? Because VIXY is not as popular as UVXY. 

Let’s compare the two next. Remember, UVXY is a leveraged ETF (1.5x), VIXY is not!

 

UVXY vs VIXY: One Year Chart

UVXY vs VIXY Performance

The above chart shows just how much faster the leveraged UVXY ETF decays when compared to VIXY. This is due of course to the leverage of 1.5 that UVXY utilizes.

In addition to contango, leveraged ETFs also decay because of their derivative nature. Double whammy!

Short-Term vs. Mid-Term Volatility ETFs

The next two funds we will be reviewing both track the performance of the S&P 500  VIX Mid-Term Futures Index. Though the short-term and mid-term VIX Indices are indeed similar (CBOE ticker SPVIXSTR and SPVIXMTR respectively),  there are some important differences in the structure and performance of volatility products the track them:

  • Short-term ETFs decay more rapidly than mid-term ETFs.

  • Short-Term VIX ETFs incorporate two VIX futures expirations.

  • Mid-Term VIX ETFs incorporate four VIX futures expirations.

Let’s jump into ProShares mid-term volatility ETF (VIXM) first.

How does the VIXM ETF work?

  • ProShares VIX Short-Term Futures ETF (VIXM) rises with increases in the expected volatility of the S&P 500, as measured by the prices of VIX futures contracts.

  • VIXM is NOT a leveraged ETF.

  • VIXM aims to provide long exposure to the S&P 500 VIX Mid-Term Futures Index.

  • The Mid-Term Futures Index is a portfolio of monthly VIX futures contracts with an average of five months to expiration.

As stated by ProShares, the VIXM ETF aims to:

In order to fully understand how VIXM differs from VIXY, we must dive into the funds holdings:

VIXM Holdings and Performance

The below image, taken from ProShares’ prospectus of VIXM, shows the funds current holdings:

As we can see, this ETF has positions in July, August, September, and October futures contracts.

The result is a weighted average of five months to expiration.

So what effect does this more time-diverse product have on the performance of VIXM? Let’s look at a 5-year chart comparing VIXM with its short-term futures ETF counterpart, VIXY:

 

As the above image clearly shows, the short-term futures ETF VIXY erodes at a far greater pace than the mid-term futures ETF VIXM.

Why is this? Contango! When futures are rolled, sometimes a premium must be paid above the spot price to do this. This premium is far greater in short-term futures than mid-term futures.

The below image (from spreadcharts.com) shows the cost of contango for short-term futures (gold) and longer-term futures (blue).

How does the VXZ ETF work?

  • iPath’s Series B S&P 500® VIX Mid-Term Futures ETN (VXZ) is designed to provide exposure to the S&P 500 VIX Mid-Term Futures underlying Index

  • VXZ is classified as an ETN (exchange-traded note)

  • VXZ performs similar to VIXM

As stated by the funds prospectus, VXZ aims to:

iPath’s Series B S&P VIX Mid-Term Futures ETF VXZ (issued by Barclays Capital) has a lot in common with VIXM.

One ostensible difference is in the funds’ nomenclature: VXZ is called an ETN. ProShares calls their funds ETFs. The truth is all futures-based ETPs (exchange-traded products) are ETNs. Good for iPath for calling a spade a spade! So what’s the difference between an ETN and an ETF?

Basically, an ETN is a debt security issued by a bank. ETNs don’t pay dividends and therefore have tax advantages (there are no dividends to tax).

If you’d like to compare the differences between ETNs and ETFs in-depth, check out our article, “ETN vs ETP vs ETC vs ETF“.

But, again, all the “funds” listed in this article are ETNs. ETFs generally perform more like mutual funds in that most have equity exposure. 

VXZ is an inferior product to VIXM in almost every way. Here are a few

VIXM vs. VXZ: 3 Differences

  • VXZ charges a fee of 0.89%; VIXM charges a fee of 0.85%.

  • VIXM trades an average of 150k shares/day; VXZ trades an average of 56k shares/day.

  • VXM option markets are incredibly wide.

Options traders should avoid VXZ at all costs. Limit orders are essential here. 

Why? In addition to VXZs low open interest and volume, you could park a truck between the bid/ask spread!

Take a look at the current options markets for VXZ calls and puts on tastyworks:

VXZ Options

VIXM vs VXZ: Performance

Let’s end our mid-term futures-based ETFs segment by taking a look at the historical 3-year performance of ProShares’ VIXM (blue) and iPaths’ VXZ (grey) ETNs. As you can see, they perform almost the exact same.

Chart from barchart.com

How does the SVXY ETF work?

  • ProShares Short VIX Short-Term Futures ETF (SVXY) is benchmarked to the S&P 500 VIX Short-Term Futures Index.

  • SVXY is a SHORT ETF, meaning this product rises in value when volatility decreases.

  • SVXY attempts to replicate -0.5x the return of the S&P VIX Short-Term Futures Index.

Last on our list is an inverse fund: ProShares SVXY. SVXY is currently the only inverse volatility ETF in existence. Here is how ProShares describes their fund in the prospectus:

SVXY Holdings and Performance

The below image, taken from the prospectus of ProShares Short VIX Short-Term Futures ETF (SVXY), shows the funds current holdings.

The holdings of SVXY are very similar to those of UVXY and VIXY. The one notable exception is that the futures contracts held with SVXY are short, not long. 

Not shown in the holdings are SVXYs leverage structure: this fund shorts the S&P 500 VIX Short-Term Futures Index at half leverage.

As we said before, because of contango, short-term (and mid-term) futures-based ETFs are a bad idea. So if buying them is a poor investment, wouldn’t selling them be a good idea? Sometimes. And this is the reason behind SVXYs high trading volume. 

Let’s compare a 5-year chart of SVXY to VIXY. Remember, SVXY is leveraged at a 0.5x ratio while VIXY is leveraged at a 1x ratio. 

One Year Chart: SVXY vs VIXY

svxy vs vixy one year

Based only on this chart, SVXY may seem like a decent long-term investment. 

Let’s compare the same ETFs, but let’s now extend the chart to 5 years. 

Five Year Chart: SVXY vs VIXY

Pay particular attention to what happened in 2018. This event was known as “Volpocalypse“. 

This event occurred in February of 2018 when the VIX doubled and the markets tanked. 

I was working with several advisors during this time that were short put options in SVXY. Needless to say, it was a bad day for them!

UVIX vs SVIX

On the tail of Barclay’s shutting down VXX, Volatility Shares announced the launch of to two new products:

The 2x Long VIX Futures ETF (TickerUVIX) seeks to provide daily investment results, before fees and expenses, that correspond to 2x the Long VIX Futures Index (Ticker: LONGVOL).

➥Want to learn more about this ETF? Check out our article, What is UVIX?

The -1x Short VIX Futures ETF (Ticker: SVIX) seeks to provide daily investment results, before fees and expenses, that correspond to the Short VIX Futures Index (Ticker: SHORTVOL).

➥ Want to learn more about this ETF? Check out our article, What is SVIX?

 

Risks of VIX ETFs

Let’s conclude the article by going over two major risks that volatility-based products introduce to traders:

1.) Volatility ETFs Do No Track the VIX

Because of contango and backwardation, volatility ETFs diverge substantially from the VIX spot index. 

2.) Volatility ETFs Shed Value Persistently

In normal markets, volatility ETFs perpetually decline in value. The exception here of course is SVXY, but after learning about “volpocalypse” we can see that not even these products are safe!

Recommended Video

Next Lesson

ETF vs. ETN vs. ETP vs. ETC: Here’s How They Differ

Exchange-traded products (ETPs) allow investors access to securities without having to directly invest in those securities. These securities include, but are not limited to 1.) baskets of stocks 2.) debt instruments 3.) individual or baskets of commodities. 

This article is going to explore and compare a few of the more popular exchange-traded products. All products on our list are exchange-traded, meaning you can trade them with your broker on stock exchanges. 

Let’s start off with a brief description of the various ETPs we will be exploring and comparing in this article:

1.) ETP (Exchange-Traded Product)

All of the securities on our list fall under the ETP (exchange-traded product) umbrella. 

2.) ETF (Exchange-Traded Fund)

ETFs are the most popular and generally the most liquid of products of all ETPs. An ETF is a basket of securities that tracks an underlying index, typically composed of stocks. 

3.) ETN (Exchange-Traded Note)

ETNs are bank-issued unsecured debt securities. ETNs track an underlying index without owning the underlying asset.

4.) ETC (Exchange-Traded Commodity)

ETCs are exchange-traded products that track and fluctuate with the price of a commodity or a basket of commodities. ETCs are most common in Europe. 

What is an ETP (Exchange-Traded Product)?

  • ETPs track securities on a wide array of securities, such as stocks, bonds, cryptocurrencies, normal currencies and commodities.
  • ETPs trade on exchanges just as stocks do.
  • ETPs generally provide investors with a more cost-efficient alternative to mutual funds. 
  • The value of ETPs is in constant flux with the market. 

Exchange-Traded Products (ETPs) Definition: ETPs are financial products that trade on public exchanges that give investors exposure to a wide array of securities.

All funds on our list (ETFs, ETNs, and ETCs) are considered exchange-traded products.

These funds have been exploding in popularity. Why? ETPs offer investors a simple and low-cost way to diversify their portfolios.  Some ETPs funds offer investors access to thousands of underlying stocks!

Unlike mutual funds, ETPs trade actively during market hours. You can buy and sell ETPs at any time of the day. These funds can even be traded when the market is closed when using the EXT TIF order type

This is unlike mutual funds, which can only be open and closed at one point of the day. Additionally, the fill price you receive on mutual funds is unknown. With ETPs, you can use specific order types, such as a limit order, stop-limit order, and stop-loss order.

The most popular ETP is the ETF. Let’s take a look at exchange-traded funds next!

What is an ETF (Exchange-Traded Fund)?

  • ETFs trade on an exchange and can be purchased and sold just like stocks can. 
  • ETFs cover a wide spectrum of investments, which include domestic stocks, international stocks, commodities, and bonds.
  • ETFs are growing in popularity among long-term investors due to their low cost, high liquidity nature.

Exchange-Traded Fund (ETF) Definition: ETFs represent a basket of securities investors can buy or sell through a brokerage firm.

The vast majority of ETPs are ETFs. According to Business Insider, 97% of the $5 trillion global ETP market consists of exchange-traded funds

So how do ETFs work? For an in-depth analysis, check out our article “ETFs Explained: Investing Basics”.

In a nutshell, here’s how ETFs work:

How Are ETFs Created?

  1. An ETF issuer creates a fund that holds the underlying securities.
  2. The fund is broken down into individual shares which smaller individual investors can buy and sell.
  3. These shares are listed on an exchange and actively traded.

After an ETF is listed, authorized participants are called upon to keep the value of the ETF in line with that of the underlying basket of securities. If the fund is trading above its NAV (net asset value), these participants will purchase shares of the individual securities that constitute the fund to bring their value in line with the ETF.

So how many types of ETFs are there? A lot! Here are a few of the more popular fund types.

Types of ETF Asset Classes

  • Stock (Equity) ETFs

Stock market ETFs are created to track equity sectors and indices. The most popular of all ETPs is State Street’s SPY ETF. SPY is an index fund that tracks the performance and yield of all 500 stocks within the S&P 500 benchmark index. They do this for the low expense ratio (fee) of 0.09%

  • Bond ETFs

Bond ETFs provide investors with a regular source of income. Bond ETFs are less concerned with price appreciation for this reason. When purchasing bond ETFs, always look at the yield before looking at the ETFs’ historical performance!

  • Commodity ETFs

Commodity ETFs invest in physical commodities. These can include oil, gold, currencies and precious metals. 

Unlike other ETFs, commodity ETFs generally only invest in a single commodity. Because of this lack of diversification, you may be wondering why these products are called “funds” at all. Some countries don’t consider these products’ ETFs for this reason, but ETCs (exchange-traded commodities). More on this to come!

Commodity ETFs can either 1.) hold the actual physical commodity or 2.) hold futures contracts that track the performance of that commodity. 

When tracking commodities via futures contracts, commodity ETFs can deviate greatly from the “spot” price of the actual commodity. This is called “contango” and “backwardation”. You’ve been warned!

  • Cryptocurrency ETFs

Cryptocurrency ETFs are the newest ETPs on our list. The most popular crypto ETF is BITO by ProShares. This is a bitcoin-linked ETF that tracks the coin via futures contracts. Refer to our above caution box to see why this may be a bad idea!

If you’d like to learn more about Proshares BITO ETF check out our article, “ProShares BITO ETF Explained“.

  • Leveraged ETFs

Leveraged ETFs provide investors with leveraged exposure to an underlying commodity or basket of securities. Leveraged ETFs use opaque “swap” contracts to achieve this leverage. The greater the leverage, the greater the tracking error and risk. The below image (from Tony Cooper) shows the historical return of various leveraged products over a long duration. Leveraged ETFs are not designed for long-term investors.

Leveraged ETF Study

Some of the more popular leveraged ETFs include:

  • SPUU (Direxion Daily S&P 500 Bull 2X Shares ETF)
  • UPRO (The Direxion Daily S&P 500 Bull 3x ETF)
  • QLD (ProShares Ultra QQQ 2x ETF)
  • TQQQ (Proshares Ultra QQQ 3x ETF)

Learn more about leveraged ETFS in our video below!

Additionally, ETFs can be options-based. Options trading (specifically covered call writing) can provide investors with extra income – and risk!

Read: 7 Covered Call ETFs and How They Work

What is an ETN (Exchange-Traded Note)?

  • ETNs are unsecured, bank-issued debt securities that trade on exchanges just as stocks do.
  • ETNs are similar to bonds in structure with the exception ETNs do not pay dividends, so there are no distributions to tax.
  • At the maturity date, ETNs pay the value of the index minus any fees. 

Exchange-Traded Note (ETN) Definition: ETNs are unsecured debt securities that track an underlying index. Issuer risk is present in ETNs.

Exchange-traded notes are a bit more nebulae than ETFs. Perhaps the greatest distinction lay in their constitution. ETNs, unlike ETFs, do not actually own the securities of the index it tracks. 

Instead, through various financial instruments, ETNs simply pay the return of a specific index. With no actual security base, ETNs behave more like bonds.  

Since there are no underlying securities held, the health of ETNs is contingent upon the health of the issuing financial institution. Therefore, the credit rating of the issuer is of utmost importance in determining an ETNs credit risk.

Some of the more popular ETNs include market volatility products related to the VIX index include Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) and ProShares Ultra VIX Short Term Futures ETF (UVXY). During the financial crisis, many volatility products imploded. 

What is an ETC (Exchange-Traded Commodity)?

  • ETCs (exchange-traded commodities) are the European equivalent of American single commodity-based ETFs.
  • ETCs are most similar to ETFs and are settled in the same fashion.

Exchange-Traded Commodity (ETC) Definition: ETCs (most common in Europe and Australia) are bank-issued securities that track a single commodity. 

We covered earlier the various exchange-traded funds (ETFs) that track commodities.

In Europe and Australia, these types of funds are called exchange-traded commodities (ETCs). 

Why? The regulatory bodies of these countries do not believe these types of products should be called “funds” due to their lack of diversification. 

Like American commodity ETFs, ETCs can be linked to a commodity through its spot price or via the futures market. As we said before, products that are linked via futures have more risk than those linked via the spot market.

Let’s take a closer look at the differences between ETFs and ETCs next, then finish the article by comparing all 3 types of funds on our list.

Exchange-Traded Fund (ETF) vs Exchange-Traded Commodity (ETC)

ETF vs ETC: Regulation and Nomenclature

  • ETCs fall under the EU’s directive UCITS (Undertaking for Collective Investment in Transferable Securities), which requires funds with exposure to only one commodity be deemed an “ETC”, or exchange-traded commodity. ETCs that contain a basket of commodities can indeed be called an ETF under this ruling. 
  • In the United States, commodity ETFs are regulated by the Commodities Futures Trading Commission (CFTC). The CFTC allows commodity funds to be called “ETFs” even when that fund invests in a  single commodity. 

ETF vs ETC: Risk Exposure

  • Commodity ETFs invest directly in a commodity, either via the spot market or futures contracts, and have market risk.
  • Exchange-Traded Commodities (ETCs) are debt securities issued by banks and therefore have default and market risk.

ETF vs ETN vs ETC: What's The Difference?

ETF (Exchange-Traded Fund) ETN (Exchange-Traded Note) ETC (Exchange-Traded Commodity)

Asset Category

Broad

Unsecured Debt

Commodity 

Risk

Market Risk

Market Risk; Issuer Risk

Market Risk; Issuer Risk

Liquidity

Most Liquid

Less Liquid

Less Liquid

Tracking Error

High

Low

Low

Dividends

Usually Yes

No

No

Tax Treatment

Short or Long-Term Capital Gains Tax.

Short or Long-Term Capital Gains Tax.

Varies

ETF vs ETN vs ETC: FAQs

Though both ETFs and ETNs have similarities, they are structurally different. ETFs provide investors direct exposure to securities while ETNs are unsecured debt securities that track an underlying index without owning the underlying.

In addition to market risk, exchange-traded notes are subject to issuer risk. ETNs are as safe as the bank that issues them. When trading ETNs, make sure the issuing financial institution has a high credit rating. 

ETNs offer investors the benefit of access to hard-to-reach markets and accurate tracking performance. ETNs also do not issue dividends, so no tax is paid on dividends.

Exchange-traded commodities (ETCs) are not considered funds in the eyes of the European Union because they are not diversified. 

Supplemental Reading

Next Lesson

UVXY: What Is It and Is It Worth The Risk?

The ProShares Ultra VIX Short Term Futures ETF (UVXY) is a great product for traders looking to both speculate and hedge on short-term volatility. Unlike most volatility products, UVXY provides 1.5x leveraged exposure to the daily performance of the S&P 500 VIX Short-Term Futures Index.

Worth noting here is the word “daily.” Over time, because of contango loss (more to come on this) and time decay, UVXY persistently sheds value. It is because of this UVXY is not designed for long-term traders. In both neutral and bullish markets, UVXY will collapse in value. 

Should you trade Proshares Ultra VIX ETF? For most traders, UVXY is not worth the risk. Let’s break down this ETF to see why.

     TAKEAWAYS

  • UVXY tracks the short-term VIX Futures index on a 1.5x leveraged basis.

  • UVXY uses “Swaps” to achieve its 1.5 leverage.

  • UVXY decays in value over time because of “contango.”

  • Contango occurs when an expiring futures contract trades at a premium to the spot price.

  • UVXY charges a very high expense ratio of 0.95%.

What is UVXY and What Does It Track?

As stated in the fund’s prospectus, ProShares UVXY ETF aims to provide investors:

Important to note here is that the UVXY ETF (technically an exchange-traded note ETN) is correlated to VIX Futures and NOT the VIX Index. Is there a material difference here? 

Absolutely!

Though both the VIX Index and VIX futures have a negative correlation to the equity market, huge differences exist. The most important difference is the performance of the two. 

VIX Index vs. VIX Futures (UVXY): Performance

The below image (taken from spglobal.com) shows just how dramatic the performance of the VIX Index and VIX futures deviates over a 9 year period:

So why the huge difference?

Spot vs Futures: Rolling UVXY

The VIX Index is a spot index. Unlike VIX futures (which UVXY tracks on a leveraged basis), no underlying products (like shares) trade on spot indices.

This means that the VIX Index product does not need to be “rolled” to a different expiration to stay alive. Though options trading does occur on indices, since there is no tradable underlying security, contracts are settled in cash instead of shares.

Futures indices do indeed offer tradable securities. Since all future contracts expire, they must be “rolled” to the next month to stay alive.

During calm/”normal” market periods, VIX futures contracts often trade at a premium to the VIX Index.

This premium is known as “contango.” Here’s why contango in the VIX futures market causes UVXY to bleed value over time.

UVXY: Contango vs Backwardation

Contango and Backwardation Graph

 

When the VIX futures contracts are trading at a premium to the VIX index, the VIX futures are in contango.

UVXY tracks the daily performance of the two nearest monthly VIX futures, such as February and March in the above example.

 
If the VIX index remains at 15 as time passes, the February and March VIX futures will steadily lose value as they converge to 15 because a VIX futures contract at maturity will be equal to the spot price (the VIX index).
 
And since UVXY tracks the daily percentage change of a mixture of these two contracts that are steadily losing value in this scenario, UVXY loses value.

UVXY in Backwardation

If the VIX futures contracts are trading below the VIX index, then the futures are in backwardation and will gain value as they converge towards the higher VIX index (assuming the VIX index remains elevated over time).
 
In this scenario, UVXY will gain value because it tracks the daily percentage change of a mixture of these two contracts that are gaining value as they converge towards the higher VIX index.

So do we have any idea how fast, or at what rate ETFs like UVXY will decay? Maybe, and that leads us to the VIX Term Structure.

UVXY and VIX Term Structure

Understanding the VIX term structure can help us predict the rate at which products like UVXY will decay. Take a look at the below visual, which shows the historical prices of the VIX futures contracts on April 1st, 2016:

vix contango

We can see the VIX index was trading at 13. We can also see that the VIX futures contract expiring in August is trading at 19.

In this snapshot in time, UVXY would have been tracking the daily performance of the April and May VIX futures, which were at approximately 19% and 32% premiums to the VIX index.

If the VIX index remained at 13 over time, the April and May VIX futures would both fall from their 15.5 and 17.1 levels to 13. Since UVXY tracks the daily percentage changes of these contracts, UVXY would bleed value.

But what actually happened?

Over the following month, the VIX index rose 12%, but UVXY lost 17.4% because the April and May VIX futures were trading at such large premiums to the VIX index and lost substantial value over the 30-day period:

It should also be noted that at the time, UVXY had 2x leverage, tracking 2x the daily percentage change of a weighted basket of these two VIX futures contracts.

For instance, let’s say UVXY was tracking a 50% weighting in the April contract and a 50% weighting in the May contract in the middle of the roll period.

If the April contract gained 10% and the May contract also gained 10% on the same trading day, UVXY would have gained 20%.

Today, the same daily changes in the VIX futures contracts (assuming the same weightings on the trading day in question) would result in a 15% UVXY gain after its leverage was reduced to 1.5x in 2018.

UVXY: Positions and Holdings

The below visual (taken from UVXY’s issuer ProShares) shows the funds current holdings:

Notice the fund has exposure to both March and April futures.

Why two months? The UVXY ETF attempts to track a 30-day VIX futures contract, but since there’s not always a futures contract with exactly 30 days to settlement, they hold a specific weighting of the nearest monthly contracts that gives them a weighted 30-day portfolio.

Put more simply, if the March contract had 15 days to settlement and the April contract had 45 days to settlement, a 50% weighting in each contract would give them a “weighted 30-day VIX futures contract.”

15 Days to Settlement x 50% Weight = 7.5 Days to Settlement

45 Days to Settlement x 50% Weight = 22.5 Days to Settlement

7.5 + 22.5 = 30 Days to Settlement.

The proportion of front month and next month futures are in a state of perpetual flux. As March settlement approaches, ProShares will increasingly shift its holdings to the April contract, reaching a 100% weighting when the March contract settles.

 
Each day after that, the fund will sell a portion of its April VIX futures and buy some May VIX futures. The process repeats indefinitely.

But what about that short-term swap? This is where the leverage comes into play.

UVXY's 1.5X Leverage: SWAPs

Many savvy investors are familiar with options trading. Options provide traders with great leverage

But sometimes these derivatives are not feasible for leveraged funds. 

Instead, swaps are used

Swaps are non-standardized contracts. Swaps are exceedingly opaque for this reason. We truly don’t know how ProShares obtains its 1.5x leverage, but the secret is in the sauce of that swap – whatever it may contain!

UVXY: Expense Ratio

Future-based ETFs are notoriously expensive. Why?

All that rolling is costly from both manpower and commission-based perspective. This leads to the current expense ratio for UVXY:

UVXY Fee's

UVXY Expense Ratio

ProShares UVXY  management fee of 0.95% comes in at about twice the average expense ratio of other ETFs.

When added to the cost of contango, UVXY could be a huge drag on your account. 

UVXY: Historical Returns

We said before that UVXY is reserved for short-term traders. Hopefully, the below one-year chart of UVXY will drive that point home.