How do you hedge your long positions? One solution is VIX futures or options thereof. The savvy investor knows that the VIX index is a measure of implied volatility of options on the S&P 500. For more information on what exactly VIX is there are lots of Web resources to consult.
One variation of the theme is VXX; essentially a combination of short term VIX futures, rolled regularly.
The biggest downside of VXX is that is suffers from contango (later VIX contracts more expensive than earlier expiries). This works like a built-in price decline mechanism for VXX. And you can see it! Bring up a VXX chart of a chart provider of your choice (use time span anything between 6 month and 4 years) ... what a dog! If you've never seen it - you'll be stunned (remark: VXX has gone through reverse splits; therefore the nominally high figures in earlier years).
VXX has often been criticized for this serial decline -- the counter argument being that "portfolio insurance" (which is what VIX and its derivatives are meant to be) costs money and if it is done right it does work well in bear markets -- as VIX is strongly negative correlated with the broad market. Though some say there are better ways to hedge a portfolio with than VXX.
Then: Why not turn the table on VXX: GO short on VXX! But be aware that on the downturn of the broader market -- which is when VXX is supposed to shine -- it can more double! As happened in summer 2011. Of course the IV of the broader market is the all important factor as to how much VIX and VXX rises. But even a small market dip like in spring 2012 let VXX rose from $62.68 to $90.
Remedy? There is a liquid options market of VXX -- but they are very pricey (IV >60%). Just like options in the VIX futures. Therefore, the following suggestions:
- go short VXX
- buy an o.t.m. bull call spread or iron condor of VXX options with expiration date in a couple months. Depending on strikes and expiry you may need more than one basket for an effective hedge. But especially iron condors can be effective while inexpensive.
If you wish, you may try to boost your return by selling a put beneath the current going price of VXX. Your put is covered by your short VXX position. Try to get a strike that lets the option stay out of the money under normal circumstances. It may be advisable to choose expiration no further than a couple months away. VXX could well reach $24 by February barring a sharp market drop. The advantage of VXX is that it "suffers" a predictable decline but rarely a sharp drop (other than in the direct aftermath of a market correction / VXX climb). With selling the put you earn the premium.
Be aware that being outright short a futures or ETN position theoretically carries unlimited risk, unless it is hedged.
Be also aware that being short a put option carries a high risk as the underlying may -- in theory -- may drop sharply; theoretically to zero (although it is hard to imagine how the IV can drop to zero).
Another way to play this is buying put calendar spreads, also o.t.m. Why not try a Jan/Feb $26 spread? As always with a calendar spread, all you risk is the money spent to open the position - in theory. Practically, you can almost always recover some of it if things don't turn out as expected (as the back option still has some value left when the front month's option expires).
So - if VXX is really as bad as some pundits claim, let's turn the table: One trader's loss is another person's win. Let us try to be that person.
There is one rare-occurrence but potentially big-loss tail risk: If we have 2008/9 markets all over again, VIX (the parent of VXX) could go above 100, trade in backwardation (later futures contracts cheaper than earlier ones; = the inverse of contango ==> works like a built-in price lift). Who knows how far VXX could skyrocket? The basket as described above does NOT hedge the short VXX against a monster climb.
Therefore I will actually change the short-VXX into Leap Puts d.i.t.m:
close short VXX futures.
buy to open VXX JAN17 2014 PUT $40.
That costs performance as there is an extrinsic value of about $4.20 as of today. At the current rate of decline of VXX that would take some 3 months. Also, it binds more capital as you are long the (deep in the money) put.
Of course, any bear market would change that overall timing. But any losses are limited to the capital invested. No worries there.
The plan is turn the condors into profit on any average market correction (no monster decline) or else wait for expiration of all the options and profit from the long put.
If VXX rises above and beyond the condors it is time to liquidate them. Depending when (and if) this happens, the long put can be kept and the other options can be rolled over to some other strike and later expiration.
If there is a "monstrous" rise in VXX due to (the next act of the) financial crisis, I will liquidate the VXX long put for a loss. But if that's the case there will be great opportunities to re-enter into a similar bet once the market calms down - then with even better odds for profit.
Disclosure: I am short VXX.
Additional disclosure: Besides being short VXX, I have (VXX-)bullish iron condor VXX options positions and a calendar spread open.