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Risk / Reward Now Less Favorable Of Being Short VXX.

|About: iPath S&P 500 VIX Short-Term Futures ETN (VXX)

According to my Fair Volatility Estimate (NYSE:FVE) model, VIX is now undervalued. At 9:20am CST, June 19, 2012 FVE's value is 19.5 while VIX is 17.7. Granted tomorrow morning is VIX expiration, and VIX tends to be very volatile and less reliable because small changes in bid/ask spread of out-of-the-money S&P500 Index options can change the value of VIX significantly. So VIX could easily rise to 19 on purely technical reasons without much implication to the markets. Having explained that, VIX is still undervalued at this moment.

Because VIX is not an instrument one could easily trade, we need to analyze VIX futures and related instruments. VIX July futures is at 21.6. Considering that VIX futures usually trades at a premium over VIX, it seems now fairly valued to slightly "undervalued with one month to go before its expiration. Furthermore, VIX August futures is at 23.6, which means that VIX futures contango is steep. This steep contango if it continues would continue to put considerable pressure on VIX futures related instruments such as (NYSEARCA:VXX), which carries daily rolling positions of first two front month VIX futures. The reason is that starting from tomorrow, VXX would be selling some of cheaper VIX July futures to buy more expensive VIX August futures. Because of the steep contango, VXX may not rise even if VIX does.

Some form of action by central banks to support the financial markets seems to be fully reflected now in the markets, and if the US equity market remains stable than prices of VIX futures related instruments like VXX could continue to fall, especially when considering the steep contango. Last week VIX was considerably overvalued and VIX futures even more so ahead of the Greek elections. I suggested shorting volatility in my article "What Happens To VIX After Greek Elections?". Now, with VIX and VIX futures related instruments having plunged, the risk/reward profile appears no longer to be in favor of staying short VIX futures related instruments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.