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)
