By: Steve Smith
The construction of this popular ETF drives its price towards zero. .It’s recent rally sets up an opportunity profit from the inevitable decline. This option strategy can double your money in two months.
One would think that any security that has declined 99% since it was launched five years ago would be not only be greeted with disgust by investors but would also face a delisting. Instead the iPath S&P VIX (VXX) has only seen its popularity soar. In 2011 the VXX’s average daily trading volume was 10 million shares. In 2014 it up to 25 million shares a day. That’s higher than 85% of the stocks listed in the S&P 500 Index.
But what many of these investors might not know is that the VXX has already dropped 98% and thanks to the very nature of its construction it will ultimately drop another 98%. It is the gift that will keep giving.
The VXX currently trades around $34 which seems a healthy enough number. But this volatility based ETF has undergone three 4-1 reverse stock splits. Meaning on a pre-split adjusted basis the stock has declined from $6,400 for a 99.9% loss over the past five years. And there is little doubt it is destined to continue to decline and be forced into another reverse split.
Barclay’s acknowledges as much in the security’s prospectus, stating as much, “due to the construction for this product one needs to be aware that its value will approach zero over time.”
So what the heck is going on here? To understand what’s at work we need to look at how volatility is mean reverting. Futures trade at a premium. Roll means buying high and selling low on a daily basis. This creates a headwind on the price dragging it lower over time.
Because volatility is simply a statistic and will never go away neither will the VXX. In fact is also written in the prospectus that 4-1 reverse splits can occur anytime shares fall below $25…this is truly the gift that keeps giving. The last three splits took place below $15 and took an average of 15 months between. By those measure we can have another full 30% decline from current levels.
A Fresh Chance to Sell
During the October sell-off there was a huge spike in the VIX and an accompany rally in the iPath S&P VIX. It then trickled all the way back down to a low of 25 during the first week of December.
Now iPath S&P VIX is jumping again, up to 34 level giving us another chance to set up a position that will benefit from it resuming its inevitable decline.
Be clear, the VXX can rally much higher and stay elevated for a considerable length of time. For this reason we want to use a strategy that limits our risk and also has sufficient time period for our thesis to play out.
The option strategy I’m employing is called a put spread. It involves buying a higher strike put and selling the same number of lower strike puts. Specifically;
-Buy to open January $31 put for $2.80 a contract
-Sell to open January $28 puts for $1.30 a contract
This is a $1.50 net debit for spread.
The cost represents the maximum risk. These options expire January 17, 2015. If shares of VXX decline below $28 by expiration the spread will be fully in the money and worth $3 or a 100% profit from the original cost.
Even if the stock market merely moves sideways over the next two months volatility is likely to decline. This would cause VXX to resume its decline delivering a tidy profit for our put spread.