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Discussions have intensified lately how to trade the volatility ETF (NYSEARCA:VXX). In an article from Larry Trefz, Volatility ETFs could face a short squeeze, traders and investors seem to agree on the fact that contango is ruining the longer term investment opportunities in the VXX. I already wrote two weeks ago that trading the VXX is only interesting when the volatility is extremely low. Markets have been drugged by the Fed with billions of dollars and volatility has fallen because of that. But any little event, even a half percent decline in the stock markets, could bring the volatility index (VIX) back to 'normal' levels.

Look at the chart from the past six months:

(click to enlarge)v

source:yahoo.com

Every time the index hits 12, something occurs which spurs the index to higher ground. Timing is everything in trading, and if you are lucky enough to find the right entry points you could make a decent return on your investment.

No long term investment

For long term protection of your portfolio, the VXX is not suitable. Because of the contango effect, you end up losing money every month when the underlying VIX Futures have to be rolled over to the next month. Because of the risk of unexpected events, there's an additional value in the further away VIX futures. It's basically the same with out-of-the-money puts, who are more expensive than out-of-the-money calls with the same distance from the actual stock price.

So the opposite position sounds more attractive. As a matter of fact, Larry Trefz found out there's a massive short interest in this ETF. The only problem for small investors is that hedging a short position in the VXX requires quite some capital. The VXX is based on the VIX Future, which has to be rolled over and is contango-sensitive. But the VIX Future is derived from the actual option prices of the first two months of the S&P 500 index. And that's where the difference is. Trading houses (and banks of course) with enough capital are keen on shorting the VIX Future and the VXX because they can perfectly hedge it with an option position in the S&P 500 index itself.

(click to enlarge)

source: yahoo.com

If we compare the VXX chart with the VIX chart we see the contango in progress. The VXX is even losing money when the VIX-index is stable.

So, for short term a buying opportunity occurs when the VIX-index trades around 12. For long term protection of your portfolio a VIX-futures or VXX investment could end up in tears because of contango.

Now I can understand why people who are long the VXX are hoping for a short squeeze to teach the shortsellers a lesson, as Larry wrote. But since ETNs are created and issued by financial institutions this will not happen. The issuer of the product will simply create more ETNs.

The only thing the long term VXX investors could save is a market crash. But Mr. Bernanke won't let that happen.....

Source: Why The VXX Is A Short-Term Buy And A Long-Term Sell