A Far Better Volatility Play With Significant Upside, Should We Go Off The Fiscal Cliff

| About: SPDR S&P (SPY)

I feel compelled to comment on a recent Seeking Alpha article, A Volatility Play With Significant Upside. I approve of the author's objective but totally disagree with the solution that he has suggested.

If the market, i.e., the S&P 500 tracking ETF (NYSEARCA:SPY) does crash, surely VXX will soar. But who would want to own this ETF?

Click to enlarge.

Have you ever seen such a dog? (OK, maybe you have bought one or two on occasion, but surely, your stock never did quite this badly.) On two occasions (November 9, 2010 and October 5, 2012) Barclays had to make 1 - 4 reverse splits to make the stock have a reasonable value. It never really traded at $2,000 as the graph suggests, but two reverse splits make it seem that way.

There are three big reasons why VXX is destined to consistently fall in the long run - 1) contango (which is the dominant condition the great majority of the time), 2) the mathematical glitch that takes place every day that a derivative is adjusted based on another measure (the same glitch that means you have to make 100% on your investment to get back to even if you first lose 50% of your investment), and 3) Barclay's charges a 0.89% fee to manage the ETN.

In the author's defense, he did suggest to buy VXX just for the short run. But who would want to own it at all (just in case the disaster doesn't occur)? Especially when there is an infinitely better solution to the problem facing investors over the next few weeks while the fiscal cliff controversy continues.

The simple solution is to use options on VIX rather than VXX. If the market crashes (or uncertainty grows), VIX will move higher just about in parallel with VXX. In the summer of 2011 when Greece's demise seemed imminent, both VIX and VXX approximately doubled in value over a six-week period, for example. VIX and VXX are extremely positively correlated, and VIX does not have any contango or other debilitating issues.

In a portfolio I carry out at Terry's Tips, I am long 15 VIX Dec-12 13 calls (cost $2.50) and short 9 VIX Dec-12 16 calls (sold for $1.25). I have 9 vertical spreads and 6 extra calls. I had to shell out $1125 for the vertical spreads and $1500 for the extra calls for a total investment of $2625.

Here is the risk profile graph for these positions at the December expiration (which comes on the 19th, earlier than regular options expire):

If we fall over the fiscal cliff, VIX will skyrocket and these positions will make correspondingly huge gains. If VIX climbs to 20 there would be a $3,900 gain, or about 150%. Since the mean average for VIX is actually higher than 20 (20.54), this is not such a great stretch. Every point VIX moves above 20 will result in an additional $600 gain (22% gain on the original investment) because of the six extra calls.

The neat thing about these positions is that if VIX stays exactly where it is today, on December 19 the portfolio will gain about $1,500, or about 55% on the investment. I figure that this is fiscal cliff insurance that not only doesn't cost anything, but it could pay off handsomely if VIX is flat or moves higher.

On the downside, losses start just after VIX falls a little below 15 on December 19. For the maximum loss to occur, it would have to fall all the way to 14. Check out the graph of VIX for the last two years to to see how many times it goes to 14.

For the past two years, VIX has hardly touched 14 and when it did, it soon recovered. In these times of uncertainty at home and in Europe (and who knows when another war will break out or a 9/11 event takes place), I think it is highly unlikely for VIX to fall below 15 by December 19th, even if Congress gets its act together and avoids the fiscal cliff. In spite of all the promises to compromise, it's unlikely they will do it before the December VIX options expire on the 19th, for sure.

The are many reasons you might not like to trade VIX options. Weekly options are not available. You are restricted to the regular monthly option series. Even more restricting, calendar spreads and diagonal spreads are not allowed in VIX options because the underlying entity is a derivative rather than an actual stock. You are pretty much restricted to back spreads and verticals such as the ones I am suggesting at this time.

In my opinion, the above VIX options positions should make good gains in the next three weeks regardless of whether or not the fiscal cliff issue is resolved or if it remains in limbo, and if it looks like it will fail to be resolved, the gains could be even greater.

Disclosure: I am long VIX calls, both long and short SPY options, and own VIX (the inverse of VXX). I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.