The famous saying that “the market can stay irrational longer than you can stay solvent” is true, but lost on most traders until it comes true. It seems to be especially apt for those looking to sell volatility.
There are a number of ways to short volatility, but selling the VIX futures and ETPs is the primary one. The short VXX trade has become one of the favorites, first of hedge funds and more recently for retail traders. There are some structural reasons for this that we can examine another time. The short interest tends to run quite high in the VXX, and a quick look at the chart shows why.
The VXX currently trades around $19, after hitting a new all-time low of $18.85 today. It was above $40 in mid-September. But even more telling, it touched $120 a year ago. And if we go back to February of 2009 when it started – and several reverse splits since – it was above $25,000.
So shorting the VXX is a no brainer, right? Well, not quite, as the list of those that have blown up in that trade is not so short… The VXX can move against shorts very quickly. In August of 2015 it doubled in the course of two weeks, a move that would wipe out many shorts.
Second, I worry about a trade this crowded. There has been more and more talk about the action in these ETPs moving the VIX futures market and the possibility of a massive short squeeze in the VXX strikes me as very real. There is record short interest in the VIX futures, which are the driving force behind the VXX.
So this brings me back to that irrational market/solvency issue. Presumably shorting the VXX is a good trade, long term, almost regardless of conditions (though I seriously wouldn’t suggest it). But the moves against you can be violent and significant. So that is where the use of options can have its place.
This past week we saw some long term put buying that appeared to be a trader taking a bearish position instead of shorting the stock. The problem with shorting stocks is that that they can go against you on an unlimited basis. Using puts, either long term or in-the-money, gives traders a limited risk alternative. In-the-money puts are more expensive, but they have lower time premium.
There are a few bearish option plays that have limited risk. But VXX puts are also a popular trade. The VXX options volume continues to grow, and we usually see more puts trade than calls, unlike the VIX options which see the opposite action. It appears that traders are using the VIX options largely to get long volatility and hedge equities and the VXX options to play the VIX futures term structure. So the implied volatility of the VXX options tends to run quite high. This makes outright put buying expensive if not done tactically. But, at least put buying allows one to have limited risk and stay in the trade against a potential short term set-back – as long as too much leverage isn’t used, which is almost always an issue with that irrational market/solvency problem.
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