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The iPath S&P 500 VIX Short Term Futures ETN (SYMBOL: VXX) is in a dilemma for both bulls and bears due to the contango in the VIX futures market and potential for greater market volatility.

As of Friday close the July VIX Futures were at $21.80, August VIX Futures at $23.85 and September VIX Futures at $25.40 with VXX closing at $15.89 (afterhour market price was roughly $16.29). VXX owns a mix of July and August futures and rolls July futures to August futures a little bit each day.

The potential for further increases in VIX Future prices and thereby VXX can easily occur with further market turmoil caused by bad economic numbers out of the US, China or Europe. This does not even factor in all of the problems in Europe.

The crux for someone who is bullish on volatility is that the futures are already pricing in a good amount of volatility with August at $23.85 and September at $25.40. With the VIX at $18.11, this means that the futures have priced in the likely chances of volatility being higher. Thereby the upside reward for taking a bullish stance via VXX is greatly diminished. It still exists but is not as good as it could be.

The bear case in VXX is strong as VIX futures tend to revert to the VIX as the contracts near expiration. This means that as July moves toward expiration the price of $21.80 will move closer to $18.11 each and every day (assuming that prices were to remain flat). Additionally, as VXX rolls from July to August futures, the bears cost average in VIX Futures would improve from $21.80 in July to $23.85 in August. That is a 9.40% improvement in cost average and is nothing to sneeze at given the reversion to the VIX price.

In my opinion there is both a bull and bear case for VXX and its quite tough to decide. Over the long term the bear case for VXX wins hands down because of the contango and also reversion to VIX price. The risk is that the markets enter into a period of great volatility and you could see 50-100% increases in VIX prices. Remember a 100% rise in VIX would only bring it to 36. VXX would not fully realize the entire gain but anyone bearish at current levels would not like the punch to the gut they just received.

The solution is to either remain in cash, trade other market instruments or use options to create a short-term view and a long-term view.

The ability to use options to create this dual view allows one to use VXX to hedge their existing portfolio from market volatility and possibly even make additional money. If one is not comfortable with being short shares in VXX then the trade below is not likely to be a good one.

The entire trade components (in ratio) are as follows:

  • Long 100 shares of VXX @ 15.89
  • Short 1 June 29th $17 call at $0.58 net credit
  • Short 1 January 2013 $19 call at $3.05 net credit
  • Long 1 January 2013 $13 put at $2.02 net debit

The first two components of being long shares and short $17 calls on June 29th expiration is a simple covered call transaction. The $0.58 net credit received reducing the cost average in the shares down to $15.31 and agrees for one to sell their shares at $17. This would represent a return of 11.04% or $1.69 in a week. If one is not assigned on this trade, then the following week a new call ($15, $16 or $17 call) should be sold on the next weekly expiration (July 7th expiration).

The two long-term components (January 2013 expiration) are being short a $19 call for a $3.05 net credit and being long a $13 put for a net debit of $2.02. A total net credit of $1.03.

The $13 put provides a guaranteed exit (due to contango and reversion concerns) to the short-term long shares at $15.31. The total loss thereby is capped at $2.31 (not considering future weekly call premiums received or profits).

The biggest risk is being short unhedged January 2013 $19 calls with the remaining net credit of $1.03. This means one is exposing the portfolio to being short shares at $20.03 cost average if the long shares have been taken out on a weekly covered call transaction. One would need to remember that a 50% rise in VXX would only take VXX to the $24 price level and would represent a $4 per share loss without considering profits from the long share side of the trade.

Overall, this trade structure allows one to profit in the near term if volatility prices increase while capping losses to the bullish position. To remain bearish the trader would have to make sure the January 2013 $19 calls remained unhedged by the continual sale of weekly call options against the long shares. I will post comments weekly so that people interested in the trade structure can track the potential risk and reward of this structure in regards to future market movements.

Source: VXX: Near Term Bull, Long-Term Bear