UPDATE VXX TRADE FROM 3/28/11

by Dan April 15, 2011 10:30 am • Commentary

Well I got the title of that post From March 28th right!  There definitely was some more downside….Market still under-appreciates a whole host of risks (commentary below) in my opinion, and with some of the price action this morning I am seeing in names like GOOG (down 6.5%) and INFY (down 13%) on earnings I suspect that we could be in for a rocky period over the next couple weeks.

VIX at 15.50 is stupid, I am staying long the May VXX call spread (below), but just bought some APR21 weekly 29 calls for .37.   Will look to turn this into a call spread of VIX spikes….But also look to May, I just wanted to quickly buy something when the VIX hit 15.

ORIGINAL POST From March 28, 2011:

VIX (17.91) – Probably A Bit More Downside Before The Next Spike

here was a lot of talk in the mainstream financial press over the weekend about the recent rise and fall of the VIX over the last 2 week.  To most investors the VIX is just another one of those fancy Wall Street (or in this case South LaSalle Street, that’s where the CBOE is located in Chicago) inventions to make average market participants feel they need the expertise of their well paid brokers to understand such complicated issues as market volatility.

-My personal belief is that without any sort of context, the VIX really isn’t that helpful for equity investors other than identifying panic or euphoria, and unfortunately 2 weeks ago we saw little panic in the stock market despite the aggressive short term spike in the VIX.  That sell-off was all too orderly and in very few areas, other than in the implied volatility of stocks, did you see any panic,   and thus did not demonstrate any form of capitulation, which leads me to believe that before the market can resume this bull phase and make new highs, there will need to be another test of the ~1250 low made in the SPX on March 16th.

-The VIX a week and half ago traded as high as 31.20 (intra-day) a level not seen since last July and almost back to the range that it had traded near for months around the 52 week lows of the index.  The sudden rise and fall of the so called “fear index” has drawn out those who think it could likely continue to go lower and those who think (as I do) that investors and thus the market currently under prices the potential issues that could derail this bull market (at least temporarily).

One of those who think that the VIX could remain volatile and likely rise in the coming months is Steve Sears, author of Barron’s The Striking Price column (read here).  In Saturday’s column, Sears lays out what he calls the “diametrically opposed views pacing stock trading” and states that “it is hard to have conviction about anything other than volatility” vs the fact of late,  “the market’s amazing ability to shed bad news”.   Sears list’s a whole host of “known negatives that have been discounted and cast aside”:

From Barron’s March 26, 2011

“rising oil prices; political unrest in the Middle East; crazy weather patterns that could hurt the hedge-fund-heavy retail sector; a new military action in Libya plus old wars in Afghanistan and Iraq. Don’t forget Japan’s nuclear disaster; concerns about the global supply chain; currency-market turmoil; the latest woes in Portugal, which are exacerbating the festering sore that is the European sovereign-debt crisis; dismal U.S. new-home sales data; and the sharp rise and fall of the world’s most famous investment stock-market risk barometer, the Chicago Board Options Exchange’s Volatility Index (VIX).”

Sears goes on to detail 2 option strategies that could benefit from either a surge in volatility in one, and/or a surge in equity prices above current resistance and then a surge in volatility.  I think both of Sears’ trade ideas make good sense (if you share his opinion), the second one (below) in particular is a very creative way to thread the needle on a change of circumstances, but I am largely going to focus on the long VIX call trade as it is most closely aligned with my own market views and and similar to the trade that I put on for myself last Friday.   (below my quick comment on Sears’ second trade idea)

From Barron’s March 26, 2011

“Trade One: Buy VIX calls in case volatility pops higher due to another event, like oil prices rising above $120 or another earthquake tremor in Japan, which would likely cause the stock market to pop lower. To profit from a temporary stock-market decline, consider buying the VIX May $19 call that cost $3.50 when the fear gauge was at 18.24. Buyers of the May $19 call double their money if VIX trades to 26. VIX is based on the implied volatility of a strip of Standard & Poor’s 500 Index options, so you can think of VIX calls, which increase in value if the index declines, as a fancy S&P 500 put.

MY VIEW AND POSITIONING: I can’t disagree with any of reasons for wanting to be long May or June VIX calls and as stated above I think the market didn’t satisfactorily display the level of capitulation that is indicative of a bottom and as stated above I continue to think that the market under-prices a whole of host of  risk; geopolitical, our stagnant economy at home, the continuing sovereign debt issues in Europe, rising energy and input costs and obviously the disaster in Japan and how all of this will affect U.S. corporate earnings for the balance of 2011.

-Rather than buying calls on the VIX I have been trading the VXX, the exchange traded fund that is designed to provide access to equity market volatility through CBOE Volatility Index® (the “VIX Index”) futures.

MY TRADE EXECUTED FRIDAY:

BUY the VXX May 32 / 35 call spread for .65  (stock ref 30.37)

-Buy  May 32 call for 2.20 and

-Sell May 35 call at 1.55

(note: these were the prices I paid for this spread Friday afternoon when the VIX was approximately at 17.80)

Break-Evens on May Expiration:

Upside: stock btwn 32.65  (up 7.5%) and 35 (up 15%) can make up to 2.35 (or over 3.5x the premium that you paid.

Downside: stock btwn 32.65 and 32 can lose up to .65, below 32 you lose the full .65 in premium (~2% of the underlying)

TRADE RATIONALE:

-Market is currently ignoring news that 10 days ago sent shutters through the options market and sent the SPX down almost 7% from the 52 week highs.  This sort of snap-back rally that we are seeing now is likely to overshoot a little to the upside and as the  panicked buyers of short dated premium from 2 weeks ago continue to sell that very premium in an effort to recoup whatever they can for the once over priced protection, the VIX will l likely move a bit lower in the very near-term.

-So I am looking to add a relatively decent probability trade that volatility will again spike to recent levels, my best guess that this will be at some point in the meat of Q1 earnings season some time towards the end of April.  It is important to remember that the VIX as an Index can move far greater and quicker than most single stocks or indexes with moves often registering in the double digit percentages.   6 month chart below demonstrates the movement of VIX vs SPX.

6 month VIX (red) vs SPX (yellow)           chart from LivevolPro

-I prefer buying call spreads vs an outright call purchase because short dated at the money calls are expensive and I want to lower my break-even and thus lower the probability of making money on the trade.  Make no mistake about it if you are playing for armageddon than the spread is not for you, buy outright calls.  But my ambitions are a little simpler, I think the market could be at an inflection point in the next couple weeks and i am looking to make a modest high(er) probability bet, but if nothing happens or market continues to rally, the idea of losing almost 10% 0f the underlying (VXX May 30 calls offered at 3.25) is not very palatable to me.

-I also want to add that since the VIX’s decline from the 30 level Mar 16-17th there have been many sizable moves in single stocks post earnings announcements; NKE, BBY, RIMM, RHT, and JBL to name a few that saw +10% moves in the days following.  So as the VIX has come in and the supposed “fear index” is not displaying much fear, stocks continue to move on news……So do your work around events and when you think you have the opportunity to by cheap options for stock replacement or leverage, then I strongly recommend it.

-To sum up……the current market rally from the lows made Mar. 16th  probably has a bit more legs and I am starting to work into this position, as I initiated a third to half of what I hope to be a full position if and when the VIX threatens the previous lows.

As for Sears’ second trade idea From Barron’s March 26, 2011:

Trade two: This positions investors to focus more narrowly on earnings season, the bulk of which should be over by mid-May, while also protecting/profiting against a potential market drop sparked by the expected end of QE2 in June. So far, the market isn’t focusing much on the end of easy money, but invariably it will dominate discussions.

Buy the May SPY $132, which cost $2.72 when SPY was at 130.64. If you want to lower the cost, sell the May $136 call that was recently at $1.01. The maximum profit is $2.29, a 134% return.

To profit from stock weakness around QE2’s end, buy VIX’s June $19 call in anticipation that the stock market will tumble lower when the easy money ends.

The VIX June $19 call recently cost $4.20. Investors double their money if VIX trades at $27.40.

-I really like the thought process here, as Sears identifies 2 catalysts; earnings and the end of QE2…….If you agree that the market is going higher than his suggestion to purchase SPY call spreads in May makes perfect sense, but I am not sure you need to rush out and buy both the SPY call spread in May and the VIX calls in June, I think you could probably lean towards the one scenario that you feel the most conviction on and then reverse course if you happen to be wrong.  Worst case in this second idea is that you get it wrong in both ways;  the market doesn’t rally and it actually doesn’t move at all and you lose most of the premium in both strategies, so my advice is have conviction and move your feet.