Time to Start Getting Short VXX

Aug.22.11 | About: iPath S&P (VXX)

I will lead this article off with the simple logic and warning that this is a long-term trade view and you need to build into your account the ability to withstand a massive move up in the VIX Index (and thus VXX) - a move that option books say you should not establish or should be stopped out of, but I disagree and am comfortable with the trades I will propose down below.

First, most people do not fully understand how ETFs that own futures contracts operate and the perils they face in normal times. I have written about contango and know a lot about the flaws, as I have written before on UNG. In normal climates, contango should be embedded into the VIX futures as the future is always going to have more "unknowns" and thus be more volatile. I am sure that in the next few weeks or months there will be contango and backwardation for VXX to roll their future contracts (they primarily own September future expirations with some in October), but again, I am approaching this with a very long term view - and massive gains to boot.

However, the main focus is not trying to figure out the amount of contango or backwardation for VXX but rather where prices will "ultimately" go to. Thus the potential for profits. A five-year chart works nicely and nothing fancy needs to be done at all to the chart. VIX was in the low single digits to begin 2007 and gradually increased all the way into the 70s and peaked out at 80.86 in November 2008. The VIX Index gradually declined back into the teens in 2010 before the flash crash. The flash crash took the VIX into the $40s again and a year later the VIX was back into the teens.

Fundamentally, the VIX is hard to analyze as it has no earnings and is based on the implied volatility of the S&P 500 Index options. Traders (not investors) tend to use options to hedge out positions or more likely use it as an opportunity to get leverage during volatile times. Since 2005, out of 1,670 trading days, the VIX has spent 131 days - or 8% of the days - above the $40 level. If one wanted to use the $30 level as a barometer (to account for some initial backwardation), the VIX has spent 228 days - or 13.65% of the days - above $30. Taking it even a step further fundamentally, the days above the $20 level were 757 days - or 45.3% of the time. So over a long enough period of time, fundamentally the VIX will be lower than $20 and the VXX will follow suit (not factoring in contango or backwardation). It is my belief that in the next two years that contango in the VIX (futures) will exceed backwardation, thus making VXX an even better option to short than any other volatility product (other futures based volatility ETFs count as well; it's just that VXX is my choice).

So with the VIX at $43, and VXX at $42.55, one may think that VXX is a buy, hoping for a revisit of 2008 highs. Well, I would simply prefer to short VXX and have the ability to short at higher and higher levels as volatility will eventually revert back into the low twenties, if not the low teens. For those wondering why I would take the stance, look at this chart. You can see that the VIX is up well over 50%, yet VXX is down 50%. That's contango and that is why I prefer to short VXX. Sometimes simple logic works best and yes, I have read the books by Nicholas Nassim Taleb and others. I fully understand them, the VIX product and the VXX product - but for the sake of brevity, I am keeping it simple for this article.

My personal plan of attack is much more aggressive than the one mentioned below for VXX. However, some components and strategies (not the same strike prices) that are mentioned below will be implemented next week on VXX.

The September $46-$51 1:2 call ratio trade is currently offered at a $1.35 net credit ($4.65 ask, $3.00 bid). If assigned, one would be short the VXX at $56, not counting the net credit.

To take further advantage of the current environment, one would sell the $65 calls in January 2012 for $5.00 net credit. If assigned, one would be short the VXX at $65, not counting the net credit.

The $6.35 in net credits in this trade should be used to purchase a number put options or put spreads further out in time. Some of the purchases should be done at $40-$35 strikes with a number of other purchases in the $25-20 range. One could wait to make the purchases in an attempt to take advantage of higher prices that may occur. Frankly - and this is me being of a more aggressive mindset - I wouldn't wait.

However, I need to disclose that the only way to make these trades really work out is if you have the ability in your portfolio to short those calls, take the short shares, have the ability to short more VXX shares or calls in the $70/80s (if 2008 really reoccurs) and still have the ability to withstand a higher move without getting forced out of your position due to a margin call.

For those traders who do not properly account for the risks I mention above, you will likely get plowed and forced out of your position at exactly the wrong moment.

Again, I encourage readers to reference the one-year VIX/VXX chart above to understand why I am comfortable riding a short VXX position in the face of a potential repeat of 2008.

I think it is highly probable that within two years of this date you will have seen the VXX drop into the low $20s, making the current prices of $42.55 a 50% gain for a short. That's roughly 25% annualized gain if it does take a full two years. However, if you do get the opportunity to buy puts and have short shares, your returns will be much higher than 50%.

If you simply buy put options and are not assigned shares or want to short calls, you can easily see some returns of 1,000% + in some of the put options if the low $20s occur in the next two years.

I will admit that most people will not like this trade, or may blast me because of the "fear" of being wrong or that we will live forever in a high volatility environment. I would simply ask those people, before commenting, to read about the VIX Index and how it is priced and how it has performed historically, and then overlay VXX (with contango or backwardation) into that picture.

Over the long run, I am putting a high probability that this trade will work out to the full potential of the low $20s and will be a potential home run for your portfolio trade.

Disclosure: I am short VXX shares and calls. Next week I will likely be short more calls via 1:2 call ratio trades and short calls and long puts, but will leave enough room to short more calls and buy more puts if we do see the VIX in the $80-100 range (unlikely).