The iPath S&P 500 VIX Short Term Futures TM ETN (NYSEARCA:VXX) is another way to trade volatility. I find it easier to trade the VXX options over the CBOE Volatility Index (VIX). It is important to note that the VXX doesn’t track the VIX. Instead, it looks at two months of future volatility.
Click to Enlarge Equity markets have had their ups and downs in 2016. The SPDR S&P 500 ETF Trust (NYSEARCA:SPY), after a brief scare in January, has set several all-time highs. We’ve seen two major spike recoveries, the most recent of which came after the Brexit decision in June. During each of these uncertain periods, the VIX briefly spiked. But every market scare was met with a ferocious V-shaped recovery, causing the VIX to be sold back down to its lower range around $13 per share.
Volatility deflation has been persistent in 2016. After every market scare, volatility was quickly diffused. The VIX fell back to the $12/$13 area, and the VXX made a new low.
Today, I want to use the old adage of “rinse and repeat” to finance an eventual super-spike in the volatility when the Federal Reserve finally raises rates. I’ve been of the opinion that the Fed already should have implemented its second rate hike. The Fed members have told us as much on several occasions. But in every Fed meeting statement, Janet Yellen tells us of new worries that warrant the delay of the inevitable.
Even though I still think they should raise in September, I think they’ll once more delay the hike into November or longer.
Trade #1 — Go long the VXX: Buy VXX Nov $42 call for $4.25. This is a bullish VXX trade so it’s short the SPY. I stand to gain if VXX spikes by November. To reduce my out-of-pocket expense, I want to sell shorter-term volatility. This would leave me with a VXX call calendar.
Trade #2 – Short the VXX: Sell the VXX Sep 23 $42 call for $1.40 per contract. This is a bearish VXX trade, so it’s really long the S&P 500. This trade is lined up in an opposite direction of the November calls.
To further reduce out-of-pocket expense, I add a third, middle-term trade for counter balance.
Trade #3 – Go long the VXX: Sell the VXX Oct $32 put for $1.10 per contract. This trade needs VXX to hold above $32 per share through mid October. I would suffer losses if VXX falls below my strike price.
By taking all three trades, I would ideally need the VXX to stay under $42 per share through Sept. 23. I also need it to stay above $32 through mid-October. Then I am left waiting for a spike in the VXX before mid-November so I can profit from the long November call position.
I am not obliged to hold any of these trades through expiration. I can close any of them at any time for partial gains or losses. However, I will not be short naked VXX calls at any time, so I won’t sell the VXX November calls before the September calls expire worthless.
That brings me to one more trade to follow up on this setup:
Trade #4 – Short the VXX: If the Sept. 23 calls sold expire worthless, I can choose to sell the following week’s $42 calls to further reduce my entry price in the Nov $42 calls. This is a decision I would make at the time based on premium available. It is not a set path but rather an optional way to go.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and StockTwits at @racernic.
