Why I Am Short VXX

Includes: SPY, VXX
by: Erick McKitterick

I have always been a VOL junkie and options are my game. I've been successful trading options in the past and gotten destroyed doing it as well, so I know the feelings of everyone out there who have taken hits recently. I would, however, like to send your attention to a very specific trade which has hit my radar recently.

The interesting trade of the day in my mind Friday came very early in the morning when 110,000 + Option call spread hit the wire on the VIX. The DEC 35 / 55 call spread appears to have been purchased 110K times, and this was an interesting trade so early in the day on what appeared to be an up day in the market early on. The reason why this trade is so interesting is simple. It is effectively a 30+ million dollar bet that somewhere in the next 29 days prior to VIX DEC settlement we may see a very big spike in VOL in the upcoming weeks.

Effectively they spent a little over 3.00 to make a potential max profit of 20.00. This is a very high risk / high reward trade. Just the Theta or Time Decay of this thesis is more than 300,000 USD per day.

If you think about it, they very well may be right. What positive catalysts do we have in the upcoming weeks? Fundamentals of existing earnings look good and the outlook from most companies is what I would consider cautious to upbeat. Few companies reporting lowered guidance; in fact, quite a few actually raised 2012 guidance moving forward. In the US GDP and unemployment I see very few potential positive surprises.

On a fundamental basis this is why I am short the VXX weekly call backspread although this is contrary to the underlying VIX trade. I believe the weekly call backspread will allow to profit from a slightly down, flat, or even up Thanksgiving week. The VXX is a flawed instrument which will lose value in almost any type of market other than in a sharp selloff.

On the negative side I see a lot of potential attacks the bears may use to fuel this recent downturn. For example, upcoming events such as German GDP, Italy Bond Yields, Greece, Spain, and just the Eurozone in general, combined with any falter in the so called Super Committee, could easily produce 1180 on the S&P.

Click to enlarge

S&P Chart provided by TradeMonster Inc.

The problem is this market seems to be extremely technically driven at this point. Right now we have broken all support except for the 50 dma on the S&P which currently sits at around 1207. The problem with this is if 1207 breaks we are headed lower.....much lower. If you look at the chart many people believe August through October developed a Head and Shoulders pattern, and I tend to agree. However, what if this was just Shoulder of a much larger Head and Shoulders pattern existing over a period of months? If this is the case then our next leg is down as we are on light volume.

From October lows we rallied almost 200 S&P in 3 weeks with VOL staying extremely high. This puts forward looking earnings in the S&P at a multiple which we have not seen in quite some time. However, this fundamental analysis is only under the assumption we will have no compression in earnings. In my mind if we truly were in a recovery at this point the S&P should be over 1300 with the VIX below 25. We are nowhere near this point and we have had great earnings coming from US S&P companies. However with all the uncertainty someone apparently agrees with me that we are headed lower and they were willing to place a 30 million dollar bet to back up that thesis.

Either way, long or short, get ready for an interesting year end of trading.

Disclosure: I am short VXX. I am short the weekly VXX 50/51 call backspread. I am short the 10/50 VIX strangle.