Trading Strategy: VXX and XIV vs. FAS and FAZ

Includes: FAS, FAZ, VXX, XIV
by: David Oldenburg
The Strategy
In my opinion, the ultimate trading strategy is one that has the potential for a big win while delivering a consistent profit each month. Traders who trade Iron Condors try to profit a little each month but can get crushed when the market moves too rapidly in any one direction. Traders who bet with a long straddle that the market will break out in one direction or the other get crushed if the market trades flat and time decay erodes all profit. What we really need is a strategy that is designed to deliver consistent profit, like an Iron Condor, with the ability to profit if the market breaks out. While it is too early to tell for sure, it appears going long VXX and XIV, at the same time, could be the best of both worlds.
Two Shorts Not the Same Animal as Two Longs
We all know VXX is a loser and has lost 90% of its value over two years. It is the perfect short but we are all afraid to short it because of the "what if." What if the market collapses like 2008 and the stock that has lost 90% over two years suddenly doubles in a few days? We could lose all of our money in a very short period of time. There are ways to hedge this risk and I have spoken about them in a previous article. I have also spoken about a few gutsy traders who simultaneously short similar leveraged ETFs, like FAS and FAZ and try to profit from the fact that they both under-perform over time.
However, going long two stocks or ETFs is a whole different ball game. Shorting two ETFs like FAZ and FAS sets you up for a potentially unlimited loss because one can only go to zero, while the other one could rise with no limits. Going long VXX and XIV is actually profitable if one breaks out because one will gain with no limits and the other can only go to zero. In addition, how one rises and also falls is also different.
Gain Does Not Equal Loss
Let's say that we bought VXX at $100 per share and we bought XIV at $100 per share. We spent $10,000 on each purchase, so we own 100 shares of each. Now volatility goes crazy and jumps 20% each day for four days in a row. The VXX would rise as follows: $120 on day one, $144 on day two, $172.80 on day three and $207.36 on day four. In other words, the VXX position is up more than 100% in four days and we are long ... so our $10,000 investment is now worth over $20,000. Our XIV also loses 20% each day for four days and it looks like this: $80 on day one, $64.00 on day two, $51.20 on day three and $40.96 on day four. In other words, our XIV position has lost about $6,000 and our VXX position has gained about $10,000, making our total gain $4,000.
Time Decay Can Ruin This Trade
The reason that most people will not attempt this kind of strategy is because of the slow decay that most long and inverse ETFs have on each other. Again, a perfect example is FAZ and FAS, which both will lose money over time. If neither one ever breaks out, you just slowly lose your investment.
VXX and XIV Different?
This may be where VXX and XIV are different. XIV has only been trading since the end of November 2010, so I caution anyone from trying this strategy until more of a track record can be established. Then again, the numbers for the first 70 days or so are very compelling. If you went long on both the VXX and XIV back at the end of November, your portfolio would be up about 18%. Not bad for just over two months. This is because XIV appears to go up slightly more than VXX goes down. This is true over the last 30 days, last 60 days and since XIV was introduced about 70 days ago.
Why You Need to be Careful
As I showed above, if the VXX has a major breakout, this strategy would be profitable and it appears it may be profitable if VXX is dropping or trading flat. However, we have not seen what it will do in an environment where volatility is slowly increasing and going higher. This situation has not yet been seen in the last 70 days.
One Other Option
I am considering a 100% long XIV and 75% long VXX because it would have returned about 30% in the last 70 days and I believe that VXX will continue its slow march toward zero. I also believe that a major volatility event would increase VXX enough to offset the loss on XIV, as I pointed out above in the four-day example of rising volatility.
When to Put This Trade on
While past performance of both VXX and XIV do not guarantee future results. This is a trade that I believe over time will be profitable in almost any market. Even with the big volatility last year when VXX traded around $120, it is now back to around $28. However, this trade has the highest probability of being profitable when volatility is high and it is entered at that time. Of course, if volatility was really high, you could also just go long XIV and not buy VXX at all. As always, don't do any of these trades unless you are experienced and can afford to lose money if the trade goes against you. In two weeks I will be speaking on my show about some of the many volatility plays that we read about each day. Good luck to everyone!
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VXX over the next 72 hours.