Volatility Soars – Profit on the Other Side with VXX
Wednesday, November 02, 2011
Volatility ETF options relatively cheap in this rollercoaster market.
It is definitely tough to gauge the reaction to these news events hitting the market, and the velocity of the moves is causing a lot of anxiety among traders - it just feeds on itself.
Yesterday was another horrible day for stocks with the Dow Jones shedding almost 300 points and the S&P 500 losing 2.79%. The big winner yesterday was the iPath S&P 500 VIX Short-Term Futures ETN (VXX) which increased 26%, adding $9.66 to close at $45.92 a share.
Stocks were crushed yesterday by the uncertainty in the European Union putting last week's deal under fire as Greece flip flops on their debt arrangement.
The market’s period of relative calm lasted all of one day!
That was how much time the Chicago Board Options Exchange’s Volatility Index, or VIX, spent below 25, generally considered the dividing line between a worried market and a not-so-worried market.
The VIX closed below 25 last Friday, which also happened to be the day the market peaked, only to swoon in the past two days.
The Index (VIX), also known as the "Fear Index" came back into focus increasing 22% in 24 hours.
The Volatility Index is based on data collected by the Chicago Board Options Exchange. Each day, the CBOE calculates a number based on prices paid for puts and calls for the S&P 500. This number gives traders an idea of the implied volatility in the market for 30 days. The VIX closed at 35.84 yesterday.
The VIX, which uses options to gauge expected moves in the S&P 500, is still far from its peak in early August of near 50 or its crisis-era peak of near 80, however, it has still been on quite a rollercoaster ride during the past three months.
It’s definitely unsettling out there!
As a direct investment in VIX (commonly referred to as spot VIX) is not possible, the iPath S&P 500 VIX Short-Term Futures ETN (AMEX: VXX), also known as the Volatility ETF is a viable option at this stage. Just yesterday, it was up almost 17%.
The roller-coaster ride started three months ago, back in August, when the VXX sat in the low 20s, clearly on its way to 0. That wasn’t to say that the CBOE Volatility Index (CBOE: VIX) – the market’s measure of short-term instability — itself would go to 0. But, rather, it simply implied that the structure of VXX was *flawed.*
How the ETF Works
The VXX proxies a 30-day VIX future -- In other words, instead of trading the futures directly, you can use a more-familiar vehicle, an ETF, to trade the explosiveness. So, in order to maintain constant duration, VXX must roll out in time every day — basically from a nearer-month future or swap to a further-out future or swap.
If the further-out VIX future trades higher than the nearer one, then the VXX will lose money every day -- And since the nearer-month future *ALWAYS* trades lower than the further one, the VXX would always lose money on the roll.
However, this did not occur *ALWAYS*, as several market-changing events happened:
• The market dropped dramatically in a short period of time,
• The VIX drove northward,
• The VIX futures curve flipped into backwardation (That is, the nearer month traded above the further month.), and
• Demand for VIX futures overall grew as the marketplace assumed a more-permanent lift in unpredictability.
All of these occurrences created a forward momentum for the VXX, propelling it to a high of 59 about four weeks ago.
The VXX Volume and Options Volatility Nowhere Near Their Highs
You can see the last quarter-year of VXX, on the graph above, where the VXX volume peaks very early in the actual VXX rally. VXX options inconsistency also has a similar standard as volume – peaking early in the rally. Even if you dollar-adjust the VXX volume for the price of the VXX itself (remember, it’s basically a hedging vehicle), volume peaked in August.
VXX options trade at a 95 volatility right now, which sounds high in a total vacuum, but not so much in terms of actual VXX action. Ten-day realized unpredictability in VXX sits at about 133 -- not far off the peak of 149 in August.
Therefore, options at 95 inconstancy, are not high vs. the action in VXX itself. But that’s not to say VXX will continue to move at a 133 volatility. However, it does say that VXX options are not particularly pricey.
Time to Profit from Unpredictability?
By owning VXX calls and puts, to hedge against regular stock is a sound method. However, to have option positions on their own is a play that needs consideration!
There’s no actual spot VIX that you can buy or sell, so the VXX and VIX futures are the most liquid ways to trade the VIX. Neither will fully track the VIX, however. The VXX more or less covers 50% of daily VIX moves, so adjust for that if you play.
Fear in the market equates to gains in the VXX.