iPath S&P 500 VIX: Time To Prepare For Bearish Trading

| About: iPath S&P (VXX)
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The iPath S&P 500 VIX ETN (NYSEARCA:VXX) is one of my favorite volatility ETNs to trade due to its active options (including weekly options) market and good liquidity in the ETN shares. VXX closed at $29.44 on. Dec. 7, 2012, and held 35.11% in December VIX futures and 64.89% in January VIX futures. It will continue to roll each day out of December VIX futures and into January VIX futures.

The VIX futures curve is currently in contango, which means that each subsequent futures contract is of a higher price than the earlier futures contract. The biggest problem with contango is that the VIX futures (what VXX owns) will always get closer to the spot VIX price as the future contracts gets closer to its expiration date. This means that unless the spot VIX price increases to $17.20, the January VIX futures contract will gradually drift down to the spot VIX price, or lose roughly 8% of its value.

What this means for VXX is that (assuming that it held 100% of January VIX futures) the NAV at $29.92 would be based on the January 2012 VIX futures and would subsequently decline 8% to $27.52. It would then repeat the same process when it starts to own February VIX futures (currently priced 15.41% over spot VIX). For a long-term investor, this means that VXX is a product to be short or bearish on, so long as there will not be any significant volatility in the markets.

Since 2004 there have been 2,246 days traded for the spot VIX, and the spot VIX price has spent 1,348 days below $20.00, or 60.02% of the days since 2004. The other 898 days or 39.98% of the time has been spent above $20, with 138 days spent above $40. There have been 231 trading days in 2012, with the daily average spot VIX price of $17.83 with a low of $13.45 and a high of $26.66.

So even with contango decay, the time to be bearish on the VXX or any volatility contract would be when volatility prices are above $20 over a very long-term period. But for active traders this does not mean one should be on the sideline and not trading VXX, because opportunities are available in the VXX options market that match the short-term and long-term view of VXX.

The 1:2 call ratio trade in March 2013 options for VXX would be the best trade to get bearish on VXX at the current time, due to the potential rise in volatility prices. The $30-$34 1:2 call ratio trade is currently being offered for a $1.41 net credit in the March 2013 options for VXX. To the long-term investor, this means that they would get bullish exposure on the shares up until $39.41 on VXX, or roughly 33.86% higher in price. If the price of VXX goes beyond $39.41, the investor would begin to lose money.

A 33.86% rise would take January VIX futures to $23.02 and the February VIX futures to $24.56. Both of these prices are optimal places to be short volatility prices based on the 2012 historical data. Data since 2004 would also be optimal since the average price was $20.85.

However, the biggest risk is that we would have volatility prices similar to fall 2008 and spring 2009 period when volatility prices for the spot VIX were above $40. This risk is minimal at this point in time, but a cautious investor could buy deep OTM call options to hedge the unhedged short calls in the 1:2 call ratio trade in order to eliminate this risk, and not materially impact the profitability or net credit of the 1:2 call ratio trade.

So an aggressive investor could do the 1:2 call ratio trade on VXX as outlined above. Or, the more cautious investor could wait until the VIX futures prices start to get above $20.00 before getting any bearish exposure to VXX.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in VXX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.