On Tuesday of this week, in my StockTalks, I announced that I was going to be taking a short position in iPath Short-Term VIX Futures ETN (VXX), an exchange traded note that tracks VIX short-term futures.
We had just witnessed the VXX spike about 20% in two days, and every single time that's happened from recent memory, it's come back down to paint lower lows just weeks later. I took my short position through December puts right before the President's speech on Tuesday. I wrongly assumed he'd deliver some sense of confidence about the government to the markets, and the VXX would pull back right away. Although the VXX wound up gaining again that day, I decided not to close my puts - and here's my reasoning why.
First, let's get a quick understanding of VXX and how it works. The VXX is an exchange traded fund used to replicate, net of expenses, the S&P 500 VIX short-term futures total return index. It's an index that offers exposure to a daily rolling long position in the first and second month VIX futures. In addition, the VXX reflects the implied volatility of the (SPY) index at points along the volatility forward curve.
The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract.
The VIX (Chicago Board Options Exchange Market Volatility Index), commonly referred to as the fear index, measures the implied volatility of index options traded. Basically, it represents the market's expectation of volatility in the coming thirty-day period.
In a bull market, like we're currently been in over the last three years, the VIX generally rides nice and low. In a bear market, or in the midst of global unease of some sort - like the government shutdown over the past week - the VIX is capable of spiking upwards, spending most of this past week over 20.
In this day and age, there are no shortage of crazy things that happen that can spike the VIX: terrorism, psychotic artificial intelligence trading algorithms gone wrong, devaluation of global currency, random NASDAQ market halts, or (even worse) swarms of viral Twitter posts about "twerking." The trick is making sure you're on the right side of whatever direction the VIX decides to head in.
The VXX is a good short-term tool - read it again, short term tool - to make money off volatility that you may see coming. Today, I'm going to argue my case as to why I've decided to short the VXX.
Reason #1 - Janet "The Stimulator" Yellen
A cheeky little move from the POTUS with the mostess over the last week. Figuring the squads on both sides of the aisle weren't going to be able to come to a resolution over the shutdown, he pulled another trick out of his sleeve to give the markets some comfort by nominating Janet Yellen as the next head of the Federal Reserve. He called an audible to help the markets, and it worked.
To start, let me just set the record straight on where I sit with financial fundamentals. I come from the "old school" of Austrian economics. Austrian economics dictates (basically) that market corrections and pullbacks are good things - they represent the actual supply and demand of products and services and how they correspond to a company's valuation.
Would it have been my first pick for the new head of the Fed? Absolutely not. Is there a good chance that we're going to be facing QE-infinity going forward? Yes. Is it definitely going to ease the fears of "smart money" and market sentiment going forward? More than likely.
Yellen has publicly stated numerous times that she's in no hurry to reverse government stimulus. This gives immense comfort to current investors today, while possibly screwing future generations and definitely giving Ron Paul a potential cardiac arrest.
I'm torn here - because from a financial fundamental level, I really dislike it. I know it may not come back immediately to bite us in the ass, but the inflation coming in the future will likely be brutal.
However, you have to play the hand you're dealt, and I'm never against reading circumstances to make money right now - Yellen is reason #1 that I'm betting on the VXX to continue to pull back before my December expiration.
Reason #2 - Government Resolve Coming
Regardless of what you think about the boobs in the government right now, we know of two things:
1. The markets have been negatively affected and volatility has gone up as a direct result of the government shutdown, uncertainty, and impending worries about whether or not we're going to deal with the debt ceiling issue.
2. We are almost certainly going to have these issues resolved at some point relatively soon.
Let's just use the ole' noggin here folks, the government shutdown isn't going to last much longer - politicians know that they're starting to really look like idiots to the American public and in the interest of protecting their reputations (oh, and helping America, too), they're going to get to work negotiating a deal to re-open the government. Even this morning, it was reported that the GOP had started to shift their demands for the Democrats a bit, a sign that the two groups are starting to take baby steps towards resolving issues with one another.
When the government re-opens, the first item that's going to get taken care of is the debt ceiling. There is absolutely no other option. Defaulting on our debt would be the single biggest financial catastrophe since the housing market imploded, and would downgrade our credit worldwide - it's something that we absolutely cannot risk; and it's my opinion that we won't.
When these two issues are resolved, likely as soon as a couple of weeks from now, volatility will again go away - making a VXX short a lucrative position.
Reason #3 - Going Short is "Betting With the House"
With over $6 billion that has poured into VXX since its inception, it only holds $1.3 billion in assets. The other $5 billion? Gone - VXX decays like an option; making it an almost no brainer short during times of comfort and low volatility.
Making money on VXX or other volatility instruments is all about making sure that the short-term timing is right. Sure, you can get burned on small spikes of the VIX, when shorts are squeezed out of VXX - but, being short is almost the de facto position for VXX, and this investor contends that the time is right to take a short position on volatility for the next couple of weeks or possibly months, depending on how things go in coming days.
There is also the benefit associated with contango. Contango is one of the first things you need to learn about when dealing with ETNs like VXX. Contango occurs when the delivery price of a futures contract has to converge downward to meet the futures price. Due to the fact that futures prices fall, contango winds up helping short positions and you wind up with a chart like the one above.
Investopedia offers up a good example of contango:
For example, assume an investor goes long a futures contract today at $100. The contract is due in one year. If the expected future spot price is $70, the market is in contango, and the futures price will have to fall (unless the future spot price changes) to converge with the expected future spot price.
The opposite of contango is known as normal backwardation. A market is "in backwardation" when the futures price is below the expected future spot price for a particular commodity. This is favorable for investors who have long positions since they want the futures price to rise.
It's for these three reasons that I staked my short in VXX and will continue to do so in coming weeks. I hope this article offers some perspective into not only VXX as an instrument, but the coming macro conditions for the market. As always, I wish all investors the best of luck.
Ways to Trade Volatility