Unusual Option Opportunity Using VXX

As you probably know, VIX is a volatility index, a measure of the implied volatility of the option prices on the S&P 500 tracking stock, SPY. VIX is often called the “Fear Index” since it tends to rise when the market falls or investors are concerned about the future.  When VIX is high, option prices in general are high, and vice versa.

Unfortunately, you can’t trade VIX.  It is just a measure of how high option prices are.  However, another instrument was created that is designed to mirror VIX, and you can trade this one.  It is an ETN called VXX.  Its value is derived from the futures prices of VIX and is supposed to be highly correlated with the volatility measure VIX.

Since VIX typically rises when the market (SPY) falls, VXX has been promoted as a good hedge against a stock portfolio.  Several months ago when VIX was about 16 and VXX was trading about $28, I recommended VXX as a good buy because I did not believe that VIX would trade much lower than 16, and if the two were highly correlated, that meant that VXX was unlikely to fall by very much.

At last Friday’s close, VXX was at $25.24 while VIX was at 21.85.  Over the past several months since I made my recommendation, VXX had fallen 10% while VIX had risen 35%.  That certainly is not a positive correlation.  I was bamboozled by the reports that said they were highly correlated.

I thought it would be interesting to compare the two instruments over time. Check out the graphs of the two equities for the past year:

VIX for Last 12 Months

VXX for Last 12 Months

Can you find any correlation between these two equities?  VIX has fluctuated in both directions throughout the year while VXX has done nothing but consistently move lower. In fact, last year VXX had to do a reverse 4-1 split of its shares so it would still have enough value to continue trading. While it looks from the chart that VXX traded about $120 a year ago, it was actually at only $30 (when the reverse 4-1 split took place on October 26, 2010).  The chartists had to multiply those old numbers by 4 to get them on the same scale as the current numbers.

The bottom line:  VXX is clearly a real dog, and seems destined to fall no matter what VIX does.

True, when VIX shoots higher, VXX follows right along, but VXX consistently fails to hang onto those higher numbers, even if VIX remains at the higher level.

The VXX chart suggests that selling the stock short might be a good investment idea.  I have personally done some of that, in fact. One problem may be that it might be difficult to short VXX.  Schwab (and other brokers) have VXX on their “Hard to Locate” list for borrowing to cover the short sale.  So far, I have not had problems shorting it at thinkorswim (although once I had to telephone in the order because the electronic order was rejected).

An even greater opportunity exists, however, at least in my opinion, using options.  We have created a portfolio at Terry’s Tips to carry out an option strategy for paying subscribers to mirror (or have trades executed automatically for them through the Auto-Trade service that thinkorswim offers).

Here is the risk profile graph for that portfolio for the July 16, 2011 expiration, less than four weeks from now:

This graph shows the theoretical loss or gain from a $10,000 portfolio based on VXX (currently trading at $25.24).  If the stock is at this exact same price on July 16th, the portfolio should gain about 8%.  If it falls into the $23 – $25 range, the gain should be about 10%.  On the upside, a profit should result at any stock price that is less than $28.

Since most months, VXX has steadily declined in price, it seems to us that this portfolio has a very good chance of making 100% a year if that price behavior continues into the future.

I invite you to join our service and participate in this investment opportunity along with us.  This is not just a theoretical exercise.  I have my own money riding in it, as I believe in it totally.