If there's anything the last few months has taught us about investing in U.S. stocks, it is that the stock market is a volatile place for your money to sit. We've seen massive swings up and down since the uptrend ended last summer and while those are painful for buy and hold investors, if you're nimble, you can capture some tremendous gains by getting in and out. My favorite way to trade the market in general is to buy and sell volatility as represented by the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). This ETF roughly approximates moves in volatility as measured by the VIX which also means it is inversely correlated to the broader market. My favorite setup with VXX has been to short it as the market tanks because more often than not, those kinds of situations lead to at least a relief rally and sometimes more. I believe we are setup for such a situation now and I'll lay out the case for why I think shorting VXX has a nice risk/reward here.
One thing VXX has done like clockwork in the recent past is to spike and then shoot lower. Of course, this doesn't happen every time and if you're wrong on VXX, you can be wrong in a big way in a hurry. It is of the utmost importance that positions in VXX (long or short) are small so that you don't get killed if you're wrong.
This chart shows us the last two years of VXX trading and obviously, the trend is down. VXX has the well-publicized problem of contango eating away at its value under normal circumstances so on average, the ETP will lose money over time. That is the first reason why I like to short VXX; under normal circumstances, you've got a nice tailwind helping you out. Of course, during periods of dislocation in the markets, VXX can move higher in a hurry and that presents us with opportunities.
If we look at the chart, anytime the VXX gets near overbought territory, it is usually followed by a sharp consolidation or outright selloff. That is what I'm hoping to capture; you don't need to be right about the market's ultimate destination, just that things aren't as bad as they seem right now.
So how bad are things? We just had the worst opening week for U.S. stocks in history. That's not good but what it does is introduce fear into the marketplace that can drive the VIX and VXX higher, ultimately creating an opportunity for shorting it.
This chart is ugly but we are now oversold on the 14-day RSI, something that hasn't happened since the panic low last August. In addition, we are near the 190 level on the SPDR S&P 500 Trust ETF (SPY) that has held in the past, indicating that SPY should at least stop going down and bounce here. And with stocks down several percent in just five trading days already, it is certainly due for a bounce.
This confluence of factors - an oversold market and overbought volatility - is what I love to see in setting up a short VXX trade and we have those conditions. The final piece of the puzzle is backwardation in the VIX curve indicating that short term fear is highly elevated against longer term expectations. This chart from VixCentral shows us that the VIX is firmly in contango territory and at steep levels too, nearing 10% in the short term.
This kind of setup has also been key to shorting VXX because while this kind of condition can persist for a while, it usually doesn't. That's what we're hoping for here; a reversion to the mean on volatility and the key is that we don't necessarily need a rally in the SPY to get that, we just need it to stop going down.
With all of the key factors in place here, I think VXX is due for a selloff. It is approaching overbought levels and with the SPY due for at least a consolidation, VXX should move down. Certainly, the risk/reward is skewed heavily to the downside for VXX at this point as investors have done well to short sharp rallies in VXX in the past and I don't see why this time is different. I think now is a great time to short VXX and capture gains from a market that is oversold and needs to bounce.
Disclosure: I am/we are short VXX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.