The VIX And The VXX ETF Have Probably Hit Their Short-Term Peaks

May.10.12 | About: iPath S&P (VXX)

In our prior discussion of the options and volatility cycle, we tried to demonstrate that absent any exogenous shocks, like debt debacles, earthquakes, tsunamis, and spikes in European interest rates, (to name just a few examples), volatility has a historic cycle, that peaks in the week BEFORE options expiration (OPEX). We have now approached the most volatile day historically in the cycle, day 8 before OPEX. For a review of how this works, please see these posts on the topic:

Again, as per usual, the pundits in the financial entertainment media are claiming that volatility is here to stay. Of course, it is not. IT NEVER HAS AND NEVER WILL BE. Their typical excuses this month happen to be, "sell in May," "U.S. is slowing down," "Europe is heating up again," etc. Pick one for yourself, it's pretty easy. This a classic example of reverse engineering a hypothesis for something they don't understand.

You can hammer this point home over and over again, but some people will just never learn. It is that precise human behavior that explains why Buffett and Munger specifically lay out all their secrets, tell you exactly how to generate their results, because they know that no one wants to believe it -- specifically, believe the simplicity of it.

Bill Luby's blog, VIX and More is outstanding, and provides a plethora of information surrounding volatility products, including options and futures as well as ETF's/ETNs. It is important to know the difference between ETF's and ETN's, as they track the underlying futures differently.

Furthermore, this outstanding book by Adam Warner explains the volatility cycle and how to use it effectively.

So, we can expect heightened volatility for a few more days. As next week comes to a close, the VIX should begin to fall, and the week of May 20th has the lowest average volatility in the cycle. This is of course, provided there are no events to disturb historical averages. An excellent strategy is to short the VXX or UVXY around the peak of the cycle, or in the next few days. The VXX will not cost you a ton of margin believe it or not. TD Ameritrade treats it like a large cap margin position. Imagine that, the product based on volatility is not considered necessary of special margin requirements. Hilarious.

Another strategy is to buy VXX or UVXY puts on May 21st. Every month this year, this trade has worked, as several days following OPEX have seen seen declining volatility. That matches the historical pattern perfectly. This will not work all of the time, but this has a series of tailwinds including:

  • Contango of VIX futures causing negative roll yield
  • Historical declines of volatility during that period
  • Time decay of VIX futures

These all factor into the VXX and UVXY having a long-term value of zero. There are several products out there including leveraged and futures ETFs/ETN's that have a long-term value of zero. I hope they never go away.

Disclosure: I am short VXX, UVXY.