Fade the Fear With VXX Puts

by Tyler Craig | October 9, 2013 11:20 am

While America’s stock slide might have a ways to go before all is said and done, yesterday’s bloodletting in leading indices such as the Russell 2000 and Nasdaq screamed of widespread liquidation.

Before Tuesday, many leading stocks sat above the fray, barely noticing the bear raids happening elsewhere in stock land. But with both indices falling more than 1.5%, it’s fair to say the hopes for an isolated correction have been dashed.

On a positive note, once the selling frenzy finally infects leading stocks, it suggests the current downswing might be ready for reversal.

Further buttressing the case that capitulation — or at least a short-term low — looms is the behavior of everybody’s favorite fear gauge, the CBOE Volatility Index (the VIX). Amid yesterday’s swoon, the VIX jumped to its highest levels since late June, trading up as much as 8%. As shown below, the ongoing two-week rise has driven the VIX well above its upper bollinger band into overbought territory.

VIX Fade the Fear With VXX Puts
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Contrarians looking to fade the latest uptick in fear have a variety of vehicles at their disposal. Let’s focus on the iPath S&P 500 VIX Short Term Futures ETN (VXX[1]), which is designed to track short-term VIX futures.

In the past, placing bearish trades on VXX near the end of a VIX spike has generated profits aplenty. And with VXX up some 28% from its lows, there remains a fair amount of downside to the ETN once it begins its next descent.

VXX Fade the Fear With VXX Puts
Click to Enlarge

One simple way of positioning yourself to profit from the eventual resolution of the current fear fest is to purchase Jan 17 puts on the VXX for around $2.90. By going out to January, you give yourself plenty of time to weather any further increase in the short run for the VIX and VXX. By the time January rolls around, the budget drama in D.C. should be a distant memory and the market will have returned to normal.

And — lest it’s never been brought to your attention — the VXX performs horribly during normal markets. That’s bad for volatility bulls, but oh so good for those owning puts on the volatility ETN.

As with all long put trades, the risk is limited to the initial debit paid — $2.90 in this case. The max reward is unlimited.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

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

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