Are we there yet? Are we there yet? How about now?

The first thing to look at if you want to short the $VXX or go long the $XIV is the front two months of the VIX futures. It is the most important relationship in determining if it is time to short the VXX or buy XIV, and sadly, it's still saying, "No, we aren't there yet." The October contract is still trading at a $1.80 premium to the November contract which means we are still firmly in backwardation. If you're not sure how to determine the prices of the two contracts see my post here.

These days it seems there are many impatient traders sitting in the back seat on this ride trying to talk themselves into a VXX short or long XIV. I was one of them as recently as last month. It's an easy thing to do. Volatility is mean reverting, and the VXX has been a complete dog for much of its existence. There's just one small problem with that logic. Before August 1st the VIX futures had spent 91% of the VXX's existence in contango, since they haven't closed in contango once. Until the VIX futures revert to contango you can throw out those charts showing the VXX's atrocious performance from inception to August 2011. It's an entirely different beast right now, and can remain that way for quite some time. The VXX was launched at the end of January 2009 when the VIX futures were in the later stages of a very long period of backwardation. Eighty-four of the previous ninety-six trading days the front two months of the VIX futures were in backwardation. Where this might not be 2008 in the broader markets, for the VIX futures it's beginning to look a lot like deja vu all over again.

Why is the contango/backwardation in the futures so critical to shorting VXX or going long XIV?

If you're not familiar with how these products work, needless to say before trading them you should do your own homework, start by checking here and here. Basically they keep a rolling mix of first month and second month VIX futures. Each day the VXX will sell one fraction of their front month futures and buy an equal notional amount of the second month future. The XIV does the inverse. When the front two months of VIX futures are in backwardation the VXX benefits from the daily roll and the XIV loses. Unless you have some powerful insight into where the bottom of the market will be, it doesn't make sense to fight an uphill battle. Instead wait until the VIX futures are back in contango and the roll yield is working with the trade. Sure doing so will make miss out on some money the first few days when volatility does roll over, but best of luck timing that. It's not easy, believe me.

The decision for when to initiate a long XIV or short VXX position is ultimately up to you, the trader. For my money, I'm not worried about timing the exact moment the VIX futures slip back into contango, but rather will wait for them to close that way for at least 2 straight days. Over the last two months of backwardation the futures briefly entered contango on the morning of September 16th. It was a long awaited event I'm sure celebrated by many volatility traders by initiating a much anticipated short in the VXX. The futures closed that day with a slight backwardation, and the VXX went on to rally more than 21% the next week.

(disclosures, long VXX, short VIX no position in XIV)

Contango and backwardation in the VIX term structure

@agwarner tweeted a couple of ideas for approximating the contango/backwardation state of the VIX futures structure for those who don't have access to real time VIX futures quotes. I thought I would add a couple more ideas.

One trick is to look at the VIX options, specifically the deep in the money calls. So in this case the OCT 10c and Nov 10c. They usually trade $.20 to $.30 wide markets so taking the mid point of the bid and the ask, and adding to the strike price should give you an approximation in real time within a nickle.

Alternatively if you don't have real time options quotes the CBOE website has 15 minute delayed futures quotes here.

Right now the VIX is firmly in backwardation with the Oct futures trading at a $1.80 premium to the Nov futures. This means the VXX will benefit from the daily roll and the XIV will be negatively impacted by it.

Ahoy hoy!

So my first blog post (ver. 1.1.) On Monday, which seems like a month ago, I sent my first trade idea on stocktwits. It was a call spread in VXX  selling 1 Oct 44c buying 2 Oct 54c for a .75 credit. I then planned to do a follow up blog post explaining it in more depth. Monday night I sat down to figure out this whole blogging thing and quickly got pulled in 17 directions. I decided I needed a clever first post, it can't just be a boring explanation of a trade. I wanted something with pictures, a funny story, a little bit about me, my background in trading, why I was starting a blog, etc. That post was gonna be the bomb, you'd laugh, you'd cry, you'd learn how to make a million dollars no matter what the Fed did Wednesday and stocktwits would invent an award for the sole purpose of giving it to me... As fate would have it my 3 month old had different ideas for how I'd spend my evening. The market and Olympia had designs on the rest of my week.

I drink it instead of bottled water, more cost effective!

Perhaps that introductory blog post will come this weekend, but for now, let's focus on a profitable trade idea, since that's why you are here. This trade is a new way to try to play the eventual decline in volatility while limiting exposure to the even more inevitable puking out along the way when Greece hires Leo Apotheker to manage their GLD shorts.

 So here goes.

Sell 1 VXX OCT 40p
Buy 2 VIX OCT 29p

As I write the trade can be put on for somewhere between a nickle debit and nickle credit depending on how good you are at working the order. I just paid $.03.

BUT why would one ever want to bet against volatility? We're in a global bear market, the European Union is falling apart, and Netflix is under 130! I grant you all of those points, and I too can't find reason to be optimistic today, which is why I'm looking to make a low risk high reward bet on exactly that happening. Volatility is mean reverting, eventually elevated levels in the VIX tend to get smashed back down to earth, not only does it happen when you least expect but it happens faster than one expects. Consider spring of 2009 when the VIX May futures closed at 38.75 (the current October VIX future price as of writing this) on April 27th, then fell 30% by May settlement to 27.04, the VXX fell 21%) Now I grant you that is a cherry picked date to show where the VIX went from levels we're seeing to levels where this trade would pay off. I cannot say that we will have a similar experience this month, but eventually the vix will go back under 30, and I want to get paid when it happens.

BUT what about VXX? That thing is a dog... True in most cases VXX is a dog, if you haven't read all about the roll issues I recommend checking out Bill Luby's VIX and more blog, he really does tremendous work. However, right now the VXX is befuddling everyone who's tried to short it the last two months (myself included) with it's relative out performance due to the backwardation in the VIX futures structure. It's now experiencing a positive roll yield which will cause it to hold up better in the immediate future. Eventually the futures will revert to contango, but by my estimations that will be somewhere in the low 30s on the VIX and low to mid 40s on the VXX. Consider we briefly slipped into backwardation last Friday with the VIX SEP future at 30.98 and VXX at 41.55, since then the backwardation returned to help the VXX make higher relative highs and the VIX lower relative highs.

For the sake of getting this post up I'm going to end here. There's a lot more I'd like to say, and yet at the same time I've said probably too much. Hey it's my first post, hopefully I'll get better, and you'll keep coming back. But ultimately that will be decided by the quality of my content. So think about the concept, I think it's a good one here. And please feel free to leave any questions or comments, one of the main reasons I started this blog was to generate discussions that will help me and you make smarter decisions in a tough market.

Thanks,
Dan
(full disclosure, I made this trade, along with the other one I mentioned.)