VXX is an etf that tracks 30-day constant maturity vix futures. Despite the popularity of the ETF and lots of Google searches I could not find any info on how options on this would be priced. I know it decays about 10% a month due to contango of the first 2 months volatility. So how would the no arbitrage condition work in the case of negative drift and 0% interest rates. Would this require a small tweak to the Black Scholes formula.
no arbitrage works the same way for VXX options or IBM options. You use the risk free rate to price options.
if you price them using the observed drift (here decay due to contango), you are simply doing a "prop" type of strategy that accepts to hold the risk of curve reversal (on a negative surprise even the curve can get quickly into backwardation). The sharpe may look nice but your strategy will have fat tails in the distribution of its returns.