When should the VXX be shorted ?

If you want to short safely, my recommendation is to do it only if the following conditions are simultaneously met:

1) VIX reaches very high historical levels
2) Both 1st and second month futures are very high and backwardation starts to clearly reduce or even alternate with some days of contango.

Even then you are never sure, since it could be you short under those conditions and then the VIX breaks a new record, but if the 2 conditions are met it will be quite improbable that the VIX, 1st and 2nd month go higher (since they already would be at historical highs).

So it is ideal to short at that time and simultaneously hedge the short.

You should scale your short and short several times small amounts to reduce the timing risk.

You should be prepared (hedged) to hold for long, it could be that the fear and backwardation re-surges or stubbornly remains high. It will go down on the long term, but make sure that the fear does not remain longer than you can remain solvent (or margined out)!

It could very well be that 1) and 2) do not happen, in that case the short has a smaller probability to be successful and you should consider seriously if you should do it and how.

If 1) and 2) do not happen you run a risk of shorting too soon (with all it’s nasty consequences). So in such case it becomes important to hedge your short, at least partially if conditions 1) and 2) are met and if not you should hedge even more.

I shorted a “small” amount (compared to my goal) because only condition 1) was met so I hedged it 100%, if condition 2 happens (we are closer to it) I will short more and hedge less.

PD: you can download here the historical VXX data (since 2004 when vix futures started to be traded) that supports the evidence that 1) & 2) are good shorting periods, I highlighted the shorting periods in it.

Cheers!
jrv

About jrv

I was born in Spain and lived in Belgium, Chile, France, USA, Argentina among other places. Currently I am trying to settle down in a wild place. I am "retired", even though now I dedicate more hours "working" for my investments than I ever worked in the real labor market where I used to work in IT and Banking. I am a family man, I have a lovely wife, several sons and one step daughter. I have humble tastes, I like to stay home and read about companies and investments. I started investing at 25 before the internet bubble exploded. I did not know much about investing and liked technical analysis so my results were pretty bad. Fortunately I did not have much to lose. Some years later in 2006 bored of doing only real state investments and with quite a lot of money saved I opened an account in a cheap and excellent online broker and started again. This time I did not want to commit the same mistake, so I decided to follow a model. I heard that Warren Buffett was the best at making money via stocks so I started by reading a lot about him, all of his shareholders letters and several of the books that he recommended. I learned a lot, started applying his investing principles and reading a lot of 10K's. Digested news from lots of different sources. Basically I started buying very good and cheap companies and holding them for ever if possible and if nothing changed fundamentally. When the housing crisis started I was more than 75% cash. At that time I identified good companies at incredibly cheap prices so I invested most of my savings in stocks. In less than I year I doubled. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. My wife and I decided to change our lifestyle and moved from Belgium to the beach in a wild country. The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return but specially to move away from the inhuman life of civilization and to have finally some peace and sunny weather to concentrate better on investing. Now I can think and study about companies 60 hours a week and I am doing great. I can finally do what I want full time and can proudly say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! You can learn a bit more about my portfolio by viewing it at www.kuchita.com/view/sumo.php or you may learn more about me and my family by following the link "Author's site" from the menu above.
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43 Responses to When should the VXX be shorted ?

  1. Pingback: How to calculate the effects of backwardation | The Intelligent Investor Blog

  2. Brad says:

    jrv,
    Thanks for your great posts on the VXX. I was curious how you hedge your short VXX trades. I tend to do call credit spreads to short the VXX and scale on the trade in several pieces (as you suggest above) in case volatility continues to rise. I’m still looking for the “ideal” hedge.
    Thanks,
    Brad

  3. jrv says:

    Hi Brad, my initial short is 100% hedged with at the money calls because it was quite dangerous not to hedge since backwardation was still very high and only starting so fortunately I did that otherwise I would be in trouble. I have not shorted all my goal yet and probably will only do it if conditions 1 & 2 are met in which case i will probably not hedge 100% but probably more around 50% or less since if I feel that I am shorting at a very good moment (like when those two conditions are met) then the need of hedging diminishes.

  4. The Borg says:

    Hi jrv,

    Why don’t you just buy VXX LEAP Puts. They come with a natural hedge because you can lose only your purchase price.

    Right now, if you buy the Jan 2013 30 Puts for about $7.00, don’t you think there is a huge likelyhood that your $7.00 will at least double by Jan 2013? (VXX would need to be below 16 by Jan 2013 to double your money.)

    The Borg

  5. Kainvest says:

    Wondering why not simply buy XIV to avoid any possible margin call / short squeeze?
    BTW, is there a double version of VIX?

  6. jrv says:

    i never short amount that would put me in a position to suffer a margin call and i usually fully hedge them. xiv just follows the daily inverse vxx movements but on the medium/long run i dont like its performance, but its a good idea to limit your loss if you plan to have a big position and fear being margined out by alternatively using the vxx unhedged.

    i can price the vxx but i am unable to price the xiv and i cannot sleep if i invest in an etf i cannot exactly know how to price it.

    there is a double version of xiv : tvix, but again as any leveraged etf, its not really a double at all

  7. jrv says:

    Not convinced about the puts, If you had bought vxx in 2005/2006 you could be losing more than 3 years after.

    Even if the vxx goes down to 23 fast the puts will still be unprofitable and if then after that another scare comes it would be a problem.

    The trouble I see is time value dynamics, that is if the vxx falls the puts will be closer to the vxx price and they time value increases making them hard to unload. So I would basically be betting on the vxx being under 20 in 2013 which I really have no idea if by then we are in the middle of another high volatility period.

    Alternatively if i directly short and hedge i can close the short any time in between here and 2013 if the vxx falls or I can cash the hedges if the vxx is extremely high and ride it the way down, I don’t expose myself to the problem if remaining time value left of the puts (and the puts are quite expensive because of the high volatility we have now).

  8. Jake says:

    Hi jrv,

    What do you mean by “you cannot price the xiv.” How can you price the xxv?

    Obviously, the xiv trade seems superior since you can only lose 100% of your money, and can make more than 100% on the plus side. Also, as compared to the XVV when the xiv goes against you its loses de-compound but when it goes with it gains compound to your advantage.

    If you had shorted the XXV and gone long the XIV when they were introduced right now, you would be up 15% on the XXV and down 25% on the XIV.

    But, at the start of July you would have been up about 100% on the xiv, while on up 60% on the xxv trade.

    And if you had pair traded them at the start of August, you would currently lost 77% on the xxv vs 55% on the xiv. And at times during the month you have been down 95% on the xxv and only 58% on the XIV.

    So, with all this in mind I am just wondering why you like the VXX more then the XIV? I respect your opinion on these ETFs and investing a lot, so I am just wondering what I am not seeing.

    Thanks!

  9. The Borg says:

    Hi Kainvest,

    The problem with XIV is the slippage. Very short term, XIV is fine, but and longer term, XIV has a lot of slippage compared to VXX.

    The Borg

  10. jrv says:

    xiv just follows the daily vxx price inversely but overtime it underperforms (vxx lost 99% percent of its value since 2004 whereas xiv you can not even tell how much it went up because the trading algorithm is not disclosed you just can make a model and guess….

    I could not invest in a black box, plus the vxx is only a problem if you expose yourself to margin calls (so if you put a too big percentage of you cash or if your cash amount is small) but if you hedge and you sell calls you have the benefits of leverage, protection, there are no underperformance problems like the xiv, and most importantly being in a tool you can price based on a very well disclosed algorithm.

    Keep in mind that the xiv values are just an approximation, no one knows how it would have behaved since the algo is not disclosed. I could not use an instrument like that only due to that reason.

    The advantage is of course your loss is limited but that does not (for me) justify other problems.

  11. The Borg says:

    Hi jrv,

    jrv says: “Alternatively if i directly short and hedge i can close the short any time in between here and 2013 if the vxx falls or I can cash the hedges if the vxx is extremely high and ride it the way down, I don’t expose myself to the problem if remaining time value left of the puts (and the puts are quite expensive because of the high volatility we have now).”

    The Borg says: “Can you be more specific on how you would hedge?”

    Thanks,

    The Borg

  12. jrv says:

    with dec calls you can see it specifically on my portfolio (top menu left), if by december the vxx does not start falling I would stay unhedged (unless I hedge again), I also can stay unhedged once I sell the calls (which might be any of these days actually) when I see that the probability of the vxx going higher is diminished.

    So for example: if the vxx goes to 60 I could sell the calls and ride the way down with the shorts

  13. kainvest says:

    jrv,

    VXX shows contango now as of today …
    Would you say that the two conditions for shorting VXX are met?
    That is, this is the ideal scenario for shorting VXX.

    To short VXX, one could –
    1. sell calls;
    2. buy puts;
    3. short it outright;
    4. short TVIX; (aggressive)
    5. buy XIV.

    What would you prefer?

    thanks,
    Kai

  14. jrv says:

    I like selling calls because i use less money and have the same potential profit as shorting since i keep on rolling them. Not sure both conditions (vix not so high) are met but starts to look like its close, i would short a bit already and more if it goes higher.

    The reason i dont go all in now is because the vix and its futures are not so high but i already feel comfortable with the receding backwardation.

    I would definitely be watching for a scary day to get in (in the short term), also take in account thet you usually dont go from backwardation to contango in one day, it tends to be some days of alternating contango with backwardation, so ther could be better entry opportunities and if you want to short but feel a bit uncertain you can always start with little and hedged

    in any case, it starts to look really interesting, i’m closely monitoring to add more shorts!

  15. kainvest says:

    jrv,

    when you short VXX call, do you use a spread?
    Or, how do you hedge it?
    How far out of money and time on your calls / spreads?

    thanks,
    Kai

  16. jrv says:

    Im not sure I understand so Ill tell you exactly what I’d do (actually did):

    I short a call with close maturity, so for example October. And I take deep in the money enough so that if it goes down fast i can profit but not so much that the amount to short becomes bigger than necessary.

    In practical words:

    Now I would short strike 30 October calls because they give room enough to profit if the vxx goes from 42 to 30 in a month i would make a profit of 12. If on the other hand it just goes down to 37 at the expiry date i can close the short at a profit of 5 and short again the November strike 25 call if i want to keep on going.

    I would not short an October 25 call now because its very improbable that in a month the vxx goes down so much and so fast from 42 to 25 and it would oblige me to put more money for no use for no potential benefit compared to the 30 strike.

    On the other hand I would not short the October 35 either because it is reasonably possible that the vxx goes down in a month from 42 to 35 and beyond and I do not want to limit my profits.

    That’s the rationale why 30 is the most reasonable call to short: it lets you profit and minimizes the amount of money used.

    Regarding hedging you hedge by buying a call, it can be at the money or even a bit in the money. The purchase price can be expensive so you will profit at lower vxx prices than unhedged, that means you will have to hold for longer but at least you will sleep better. If you are shorting at a very good point (backwardation receding or gone and VIX and its futures very high) the hedge becomes less necessary in which case you can not hedge also if you can withstand paper losses you can simply not hedge or you can hedge less than 100%

  17. kainvest says:

    Pretty methodical.
    Thanks for sharing.
    Kai

  18. David W. says:

    jrv,

    Thanks for your generosity. Regarding selling deep-in-the-money VXX calls, aren’t you running the risk of being assigned? Thanks.

  19. jrv says:

    I have been assigned, but that is not a problem, it just means I have to put more money in the short, even that is just temporarily because I then replace the short shares by another short call. Actually I like being assigned since it gives me the chance to realize the time value of the call.

  20. Dubi says:

    Hi jrv, from what I understand the higher vix the higher the backwardation so I cant see how conditions 1 &2 can co exist when vix goes above 40. From what I’ve seen the vix curve inverts when vix breaks up 30 so in my estiamtion the best time to take short VXX is when vix is 30 and the curve is flat, this way if market rallies and vix goes down below 20 eventually together with contango back you will have nice profit, but this trade should have a tight sl because if vix goes up again you woldn’t want to sit there for a long time and let backwardation kill your position.

  21. jrv says:

    it will not happen at the the point where the vix is the highest but yes when its very high: some time after the vix reaches a very high level and starts falling conditions coexists, so you have to see a clear downtrend before but still short when the vix is high and make sure as you say that the curve is tending to flat (backwardation disappearing)

    for example in 2009 the vix reached over 80 twice, then it fell to 60, 50, 40 and both futures followed. there you had several weeks where the futures were quite high and the backwardation was falling and even intermixed with contango, you may download the data to verify you would have not caught to top but it was a safe moment to short,

    then again nothing is completely sure the vix could have also went back up to 100 affer that but it would have been historically unique so I think quite unlikely since the vix can be seen as the price you pay to insure the s&p with options and that price is limited, so worse case I see is that you short when both conditions happen and the vix goes back up, but it eventually would go down anyways at most you would have paper losses, and if you did not short much it should not cause margin calls (or you could hedge)

  22. Dubi says:

    Thank you for the quick reply, right now I believe long VXX is the best trade in the market, the vix doesn’t seem to go below 30, that is the big support and as long as it goes sideways 30-45 the backwardation is the key factor giving big profits as you showed yourself. I think after this week the probabiliy of a big spike above 50 has also increased so I sit there and wait and enjoys backwardation in the meanwhile.

  23. Wu-man says:

    Dubi don’t be greedy. VXX is going much lower soon.

  24. MarginCall says:

    Unfortunately I shorted VXX thru selling calls way too early. Now I am facing margin call if VXX continues its march higher in next 10%.

    Wondering what I could do to mitigate the margin call risk should VXX goes up 10%?
    Thanks.

  25. jrv says:

    If you think that short term it will keep on going up you can buy deep in the money calls to protect yourself from further vxx increases by selling at a profit if the vxx increases, that will offset the losses on you short positions, but on the other side that means that if the vxx immediately falls before you can sell the benefit of your shorts will be offset by the long calls price decrease.

    So it all depends on your expectations, if you think that vxx will go higher before it goes lower you can do that.

  26. jrv says:

    or you can send more money to avoid having the margin call

  27. MarginCall says:

    Why deep in the money call?
    How about buy TVIX or SPY put spreads?

    I am afraid that sending more money might just delay the inevitable as the prolonged VXX backwardation seemly keeps getting stronger …
    I regret that I did not do my homework as you did :(
    Thanks for your good work!

  28. jrv says:

    Deep in the money hedges 100% of the vxx increase buying tvix is equivalent. It is also equivalent to close you positions now and short again at higher prices.

  29. david says:

    Should hedge the position. vxx might have chance to go way up.

  30. MarginCall says:

    How would you hedge? My Dec and Jan calls are way under water. I am thinking to buy shorter term calls like Oct or Nov at higher strike prices.
    Or any better ideas? Thanks.

  31. tangledweb says:

    When the S&P is rising xiv rises faster than vxx falls. When the S&P is falling vxx rises faster than xiv falls. That is why you see the discrepancies. Backwardation hurts both and contango helps both when playing the short side of the game. But eventually (which can be months and with the current market may much longer) backwardation always gives way to contango for some period even in a secular bear market.

  32. tangledweb says:

    I mis-wrote part of the above. Contributing to the discrepancy is that when the market is rising backwardation hurts vxx but helps xiv. When falling backwardation hurts xiv but helps vxx.

  33. david says:

    I have 85 dec call. It will not compensate all the loss but it will make sure the loss is contained.

  34. david says:

    jrv,

    Today vxx rose more than the two recent vix future. can vix have disparity with the fare price or something else?

    Thanks

  35. tangledweb says:

    Happens all the time. You can in fact see vix up and vxx down or visa versa. Vix always looking at the “future”. VXX is today.

  36. jrv says:

    vxx is a weighted average of the 1st and second vix futures the weights are taken so that it is proportional to a 30 day future vix price.

    There is always a small disparity caused by market daily offer/supply dynamics of people buying/selling the vxx in the market, but it is small and moves around the exact weighted average

    The discrepancy can be exactly quantified by calculating the VXX based on the futures and comparing it to the market price, vxx can be calculated with the number of 1st and 2nd month contracts that make it up.

  37. Kainvest says:

    To hedge, what do you think of using the underlying (i.e. buy VXX)?
    Actually you could do it as soon as the backwardation starts at an elevated VIX…
    Kai

  38. Tony says:

    It is Jan 2013, and VXX is at $7 (split adjusted due to the 4:1 split for comparison with above post), so this is much below $16. So, that trade would have been very profitable!

  39. jrv says:

    On the long run shorting VXX will be profitable most probably. That’s why I have a permanent short position since August 2011. But if you want to short safely to avoid dangerous temporary paper losses or margin calls I recommend doing it during high volatility times when both front end VIX futures are at very high levels.

    Cheers!
    jrv

  40. Kainvest says:

    XIV slippage is a mastery. In the 2011 crises, XIV drops in a faster rate than the increase of VXX ( due to backwardation? )
    However, in the recent months, XIX goes up faster than the drop of VXX (due to contango ?)

    Overall, XIV has been performed pretty well in the long term.

    Borg / Jrv,
    Do you guys think XIV can be a long term investment?

  41. jrv says:

    Hi Kainvest! Yes quite good if you manage to buy it a time when volatility is high. At least that’s what history shows. It should be bought more or less at the same time as when the vxx should be shorted.

  42. Tony says:

    Yes that is the hard part, surviving a huge upswing in volatility while shorting, and not getting a margin call. Thanks for the informative website! – Tony

  43. Kainvest says:

    To avoid the margin calls, long LEAP puts ( a year out) might not be a bad idea for shorting VXX or UVXY.

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