Traders anticipating a bullish start to the equities market in 2012 should consider taking advantage of one of the more unique volatility products available – the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX). Also known as the “Volatility ETF,” the VXX tracks a hypothetical 30-day future on the CBOE Volatility Index (CBOE:VIX).
Think of the VXX as a basket of front- and second-month VIX futures. (The front month refers to the nearest expiration cycle – that is, if it’s June 1 and your options expire in June, that is the front month.) In order to maintain a constant maturity of 30 days, it incrementally rolls the front-month futures to second-month futures on a daily basis.
The performance of VXX is a function of not only the change in value of the VIX futures contained within the basket, but also the “roll yield” that occurs due to the daily rebalancing.
In the event second-month futures are trading at higher prices than front-month futures – a phenomenon known as contango — the roll yield is negative and thus drags on the performance of the VXX.
Alternatively, when the second-month futures are trading at a discount to front-month futures – which is known as backwardation — the roll yield is positive and actually boosts the performance of the VXX.
The overwhelmingly bearish performance of VXX since its genesis in early 2009 can be attributed in large part to the tendency for VIX futures to remain in contango.
If the equities market continues to stabilize, the VIX should remain somewhat depressed. In addition, with January VIX futures sitting at $25.95 and February futures at $26.55, the roll yield is currently negative. This one-two bearish combo should continue to put downward pressure on VXX, making bearish plays all the more appealing.
One option play worth consideration is the bear call spread. Traders could “sell to open” the VXX Feb 41 Call while at the same time “buying to open” the VXX Feb 46 Call for a net credit of around 80 cents ($80 a contract). It doesn’t matter what you specifically collect for the $41 call or pay for the $46 call, as long as you collect about 80 cents per share for the overall trade.
The max reward is limited to the initial $80 (80 cents x 100) received at trade inception and will be captured as long as VXX remains below $41 by February expiration.
The max risk is limited to the distance between strike prices minus the net credit — $420 ($4.20 x 100) — and will be incurred if VXX rises above $46 by expiration.
At the time of this writing Tyler Craig had bearish positions on VXX.