The VXX and UVXY Volatility ETFs were up sharply this week leading to a Critical Trading Question:
Is it time to short VXX and UVXY?
Background: Over the last five years the UVXY Volatility ETF has declined from a split-adjusted price of 25040.00 (not a typo) to the current price of 48.81. Anyone ‘smart’ enough to have shorted UVXY back then — or, God forbid, bought put options or long put backspreads — would be rich. Very, very rich.
In the last few years, a handful of intrepid retail investors noted the strong historic returns from shorting these instruments and set up websites explaining how to achieve 90% per year compounded returns at ‘high’ risk. As opposed to the conventional view that the strategies offer 90% per year returns with ‘suicidal’ risk.
The key to the high returns results from the futures roll and the volatility decay in the ETF calculation mechanism. This can lead to long grinding losses year in and year out, under normal market conditions.
Based on the hypothetical paper trading returns cited on the Short Volatility Sites, and, quite possibly, a realized profit in an actual trading account or two, the non-professionals on these websites are outperforming the largest and most successful hedge funds by a significant margin, over multi-year time horizons. In fact, at least one 170 million dollar hedge fund was set up using strategies suspiciously similar to those described on the retail websites.
The Anti-Volatility Meme even entered popular culture via the not implausible conspiracy theory that the Federal Reserve and its lackeys at the too-big-to-fail banks systematically manipulate the volatility term structure, to enhance the “Full Faith and Credit” of the Global Monetary System.
The good news is, in our opinion, the Short Volatility strategies have a sound basis in mathematics. Even better news is that you can trade these strategies and strictly control potential drawdowns.
The key element is risk control. Because Volatility ETFs are subject to buy in risk (when short) and extinguishing clauses (when using the inverse ETFs), the expected return of the short-and-hold and buy-and-hold strategies is a 100% collapse-to-zero loss at best and an unlimited more-than-100% loss at worst. See this previous SpreadHunter blog post.
Option-to-option vertical spreads are not subject to buy in risk (when short). Nor are they exposed to open-ended, unlimited risk like short underlying units and short options contracts. However, selecting a spread to capitalize on the huge price swings in these instruments is not easy. One neutral strategy is to purchase a symmetrical pair of one week to expiration call and put spreads, as far out of the money as possible. The idea is not to trade the spreads as an iron condor but to take profits on one or even both verticals as the ETF gyrates between the spreads. Another potential strategy, for traders in JBO or Portfolio Margin Accounts, is to sell at the money time spreads. The margin on this trade is horrible for retail investors, even more than for selling naked call or puts. As a rule, VXX has greater liquidity, especially in the complex spread books.
Another possible approach is to go ‘bargain-hunting’ on the option chain to find the best value relationships for the price. In periods of very low volatility, selling short put and call verticals can be a winning strategy but in highly volatile markets, the meager premium in these spreads offers very little room for error.
As usual, position sizing is critical for long term success. Long vertical spreads can lose 100% of their value, so a small portfolio allocation of 1-2% is essential at first. It might also be a good idea to take profits as soon as possible. Once the position size gets bigger, say, 10 spreads or more, it makes sense to take moderate profits on most of the position, and leave one or two spreads on until expiration, to capture the infrequent but large profits when the spread value reaches its maximum.
In our view, trading verticals in VXX and UVXY is a great way for beginning traders to step up their game. The number one factor separating novice traders from professionals is that the professional knows how to defend a position. Because UVXY frequently drops more on a percent basis than the market did in the 1929 or 1987 crashes, new traders will get lots and lots of practice defending their positions. And be well prepared for the day when VXX and UVXY are delisted from the exchanges, and the overall market is trading like VXX and UVXY.
SpreadHunter Team
This Article is For Information Purposes and Does Not Constitute Investment Advice. The target audience for this post is Professional Traders and Investors working with Advisors. Options Trading involves risks which can be significantly greater than the amount of invested capital. The SpreadHunter Team accepts no responsibility for any losses resulting from actions inspired or influenced by this blog post.
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