When trading volatility, one can get in too deep quite easily and have a trade turn against you quickly. Since I started writing about trading the VIX products, I have had a few traders ask me for advice on losing trades and wanted to go over a recent example to outline my thought process for volatility trading.
Yesterday I had a trader come to me with the following situation:
"Hey. I read your July 19 contribution on the VXX. I bought 6,000 shares when I thought it was on sale at $15.45. How screwed am I? Any advice?"
To assess the state of the trade, we first need to look at the current performance and make estimates on the full potential for loss and gain in different scenarios.
Taking a look at today's term structure and see where we are currently stand (as of 9:12AM):
Spot VIX: 15.40
Aug Futures: 18.20
Sep Futures: 20.15
If the trader bought VXX at 15.45, they are sitting with a 19% loss on the position with it now at 12.57. Luckily the trader did not go into UVXY, as the loss would be much more painful. This is still a significant loss on sizeable position (for me at least) and we need to see what could happen if the trader stays in the position.
While I can't predict the future, I can envision possible scenarios for the future movements in spot VIX and the futures. Let's take a look at a few of them using some "napkin math" to see possible future levels in VXX.
Spot VIX heads to 15 and Aug futures head to 17. This would be the goldilocks scenario and would be a great time to double down if the trader has the dry powder available.
VXX would head to ~11.61 and any further weakness would be the result of contango eating away at the futures. Unless they are planning on holding for an extended period of time, I would put this near the maximum pain for the position. That would be another 7% lower and would cap the losses at 25%. Sometimes just knowing how bad it can get will help in weathering the storm.
Spot VIX heads to 18 and Aug Futures head to 20. This would be a normal market fluctuation and not require any nasty sell offs to come true. I put this as a fairly likely scenario for the next few weeks.
VXX would head to ~13.66 and only go higher if VIX continued spiking. This would still be a 12% loss on the principle, which is harsh, but if we do trade up this high, I would use this as a stop to prevent further losses once the trade has turned back in the trader's favor.
Spot VIX heads to 20 and Aug Futures head to 22. It is possible that some bad headlines came out from somewhere would bring us back to the top of the range in the near term, but I put a lower likelihood on this due to the recent market action.
VXX would head to ~15.02 in that scenario. This would bring the trade close to break even and should allow one to continue trading while using the loss as expensive lesson/
Spot VIX to the moon, Futures as well. War, sovereign default, natural disasters; any of these could get us into these panic levels of volatility.
VXX would break the entry point and head higher. This is really the only scenario that I see the trader being able to exit the position while making a profit. Since the wait for such a spike could go well into the future, I would not recommend waiting it out for this scenario as contango will further erode the position over time.
Summing up these scenarios, we have identified a maximum pain point and two potential selling levels as well as the required scenario for a profitable exit. If VIX starts trending up as I believe it will, the trader can use these scenarios as stop levels once they are breached and just prepare for the pre-determined losses.
Holding volatility products like VXX, UVXY and TVIX long term is a losing bet due to the near-constant contango in VIX futures. Every trade needs to have loss limits and every trader needs to abide by the limits to prevent situations like we examined today. I know I have chosen to ignore my loss limits in the past and have paid a hefty price learning that I should always honor them, no matter what. Having a "trade that got away" story is much easier when you still have capital remaining to trade again in the future.
If the trader has dry powder available, these trades can be made profitable by averaging down but they need to realize that trading volatility in the long term is a losing bet. Almost all of the volatility products out there are meant as short term trading vehicles at best.
I hope this advice helped the trader and anyone in a similar situation, it is by no means a guarantee of what will happen in the volatility markets but it hopefully provides a framework for evaluating losing trades and determining steps of action given different scenarios. As always I wish the best of luck to all traders in the volatility markets, I know we'll need it.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in UVXY over the next 72 hours.