I have this sneaking suspicion that the market is in for a very rough ride over the next few weeks. Angela Merkel's remarks this weekend weren't encouraging. Asia's not pleased with U.S. employment data released last Friday.
And now it appears that volatility might go into backwardation. Usually volatility exhibits a contango, with future months costing more than nearer months. But not always.
Here's a look at the VIX futures term structure going back almost a year and a half:
You can see that the near month (red) is usually below the more distant months. One notable exception is last summer when volatility spiked as the market tanked. Are we in for a rerun?
Here's a more detailed year-to-date chart for selected contracts:
Note that the May contract has already expired, but that the whole term structure appears to be nearly flat right now. Will it move into backwardation?
Who knows for sure? Certainly not me. It could be a false alarm. But if it's not, it's one of those occasional opportunities to be think about buying the iPath Short-Term VIX ETN (VXX),
Being long VXX usually stinks after a few weeks. The VXX has a tendency to go down over time (it began its life in 2009 at a split adjusted price of 400!), making it an unsuitable long-term hedge.
But in the short run, when volatility goes into backwardation, the VXX could easily gain 50% or more over a couple of weeks. It doubled in about a month in August 2011.
Limited risk. Targeted reward.
This is speculative view, however, so I'd consider using options to limit the risk of this trade.
For example, as of June 1, with VXX at $22.58, you could have purchased 10 July VXX 25 calls and sold 10 VXX July 35 calls for a net debit of $1550. That spread could be worth a maximum of $10,000.
Here's the payout structure, assuming constant volatility:
Volatility won't be constant, however. If I'm wrong, it will probably go down a lot, so I would not make this trade unless you were prepared to lose most of the premium.
Going out to August might make sense except that those options aren't all that liquid. Still, the July options have about 7 weeks until expiration.
Another approach might be to buy 10 options, but only sell 7 at the higher strike. This increases the net debit to $1760, but allows for further upside gains.
I'm not suggesting maintaining this ratio at 10 to 7, but by leaving some powder dry, you might be able to sell even more upside calls at higher prices, or maybe even turn the spread into some form of butterfly or condor with a guaranteed gain.
But this is a short-term opportunity. Volatility will return to contango soon enough, and when it does, VXX will plummet. It always has and always will.
It doesn't please me to even be thinking that VXX could spike so high, if only temporarily. But anything is possible in a world where 10 year bonds yield 1.5% and a continental currency crisis looms.
A new saying may even emerge:
Sell in May
And Go Away
Sell More in June
Don't Change Your Tune
And Watch VXX
Go To The Moon
Until It Goes Down
Which It Will, And Soon
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
