Profit From the Volatility Funk

by Tyler Craig | November 20, 2012 11:57 am

Profit From the Volatility Funk

With the S&P 500 Index closing up about 2% in Monday’s trading session, the bulls have finally received a much-needed respite from the house of pain they’ve been locked in  since the Nov. 6 presidential election results. Of course, despite the impressiveness of the recent snap-back rally, we remain firmly entrenched in a downtrend with declining 20- and 50-day moving averages.

While the bulls have established a small foothold in the past few days, much work remains before the damage of the past month is undone.

One group of market participants whose disenchantment is likely growing by the day are traders who purchased shares of ever-popular volatility exchange-traded note iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[1]) weeks ago in hopes of cashing in on the volatility surge that typically accompanies a broad market sell-off.

Perhaps surprising many, the VXX barely lifted even though the S&P 500 fell almost 10% over the past two months. Adding insult to injury, VXX not only remained muted during the recent market bloodbath, it even fell to a new all-time low, closing Monday at $31.70.

So what might we identify as the culprit to VXX’s recent failure to launch? Here are three likely causes:

The ole’ pre-news volatility bid-up

Volatility-based products like the CBOE Volatility Index (CBOE:VIX[2]) and VXX were already bid up in anticipation of the election results, making it all the more likely for them to drop afterwards, not rise.

Tis’ the Season

The November/December time frame isn’t exactly known for its epic volatility. Quite the contrary, realized volatility tends to remain depressed around the winter holidays. So, perhaps the expectation of less market movement on the horizon is keeping the VIX and near-dated VIX futures (which VXX is based off) subdued.

Contango Winds

Since the VIX has remained muted throughout the sell-off, the term structure of VIX futures have remained in contango, with later-dated contracts trading at higher prices than near-dated contracts. For example, the December futures contract is currently trading at $16.75, while January is trading at $18.60. As VXX rolls its holdings from December contracts to January (sell December, buy January), it will incur a negative roll yield that will drag down the fund’s performance. This so-called “contango drift” further contributed to VXX’s inability to lift.

While the election’s effect on volatility has likely played its part in this saga, the twin forces of seasonality and contango are still in full force. As a result, VXX should continue its seemingly endless trek lower.

Craig VXX chart 11 20 300x159 Profit From the Volatility Funk
Click to Enlarge
Traders looking for bearish exposure to VXX might consider buying a January 33 – 28 bear put spread for $2.90. The vertical spread will realize its max profit of $2.10 if VXX falls over 10% by January expiration. In the event the market downturn worsens and volatility catches a bid, the spread’s risk is limited to the initial $2.90 paid at trade inception and will be incurred if VXX sits above $33 at January expiration.

At the time of this writing Tyler Craig owned bearish positions on VXX.

Endnotes:
  1. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX
  2. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX

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