Just One Short: Popular Volatility ETN Is Ripe

VXX is the popular iPath S&P 500 Short-Term Volatility Futures exchange traded note (VXX). This ETN is now one of the 10 most popular trading vehicles, with nearly 15 million shares traded daily. We expect this ETN's popularity to continue its rise, and eventually become one of the top 3 most traded and followed vehicles on any exchange.

The last two weeks have yielded some interesting results in the price divergence between VIX [^VIX], the underlying volatility index and VXX, the tracking ETN. This analysis differs from previous ones in that it looks at the premium of VXX relative to VIX, rather than historic action in the VIX that would lead the VXX lower.

Investors would be wise to short VXX, independent of whether the VIX falls or remains flat from here.

Thesis

This is what Investment Underground found regarding the VXX premium:

On 2/14/11, the premium for VXX became less negative, showing a divergence between VIX and VXX. As the market entered the monthly VIX futures expiration window, there is likely more turbulence and sense of uncertainty in the market ahead. The political backdrop also added more to this uncertainty. On 2/15/11, the premiums got less negative again. The market was waiting for the “confirmation” of the “divergence” move from 2/14/11.

Next, on 2/16/11 markets showed the same result, except the Feb VIX futures contract rose significantly on large volume. The market steadied in anticipation of a meaningful confirmation of the divergence from Monday.

The market suggested a “strong sell” on 2/17/11 when the VXX premiums became more negative as the February VIX options expired. On the 18th, the premiums became even more negative. There was still additional divergence between VIX and VXX which created additional short term turbulence.

This all changed on the 22nd, which showed a key reversal in the price of the VIX and VXX. The crisis in the middle east fueled market demand for puts, and consequently increased the risk-premium implied in these volatility instruments.

On the 23rd, the same pattern of a rising VIX and VXX resulted, but the price rise was exhausted. The VIX suggests further deterioration in the markets at this point, however the relative premium of the VXX over the VIX suggests selling the ETN is the most prudent course.

To capture a short play using longer-dated VIX futures, investors should consider shorting the iPath intermediate-term volatility index ETN (VXZ).

Disclosure: I am short VXX.