The Truth about This Trending “Fear Play” and Why It’s Poisoning Your Portfolio

Several weeks ago, I warned you that the bears would be taking over in May.

And as you’ve probably noticed, we’re starting to see this bearish movement affect market volatility this month.

But there’s one index that’s faring better than the Dow Jones Industrial Average, the S&P 500, and the NASDAQ…

Known as the “fear index,” the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is an extremely popular index that measures the volatility in the markets.

Now more and more traders are playing the VIX to fatten their wallets off the back of investor fear in the markets.

But what they’re trading to make a quick buck or two is dangerous to your immediate- and future wealth.

So before you make the same mistake they are…

Let me tell you why this is the worst way you can play volatility…

3 Reasons Why I Won’t Touch VXX Options with a 10-Foot Pole… and You Shouldn’t Either

You know by now that I have a passion for studying the markets. My family, of course, is my first passion. But it’s hard for me to pull away from the markets when they’re open, and I get a bit stir-crazy when the markets are closed… that’s how deep my passion runs.

Next to my family and the markets, what I love the most are options and trading options. In fact, I love trading options on virtually every instrument out there that allows me to.

But there is one item I will not trade options on…

In fact, even if you offered me money to trade these options, I’d tell you to keep your money.

And I’m talking about VXX options…

These options are like the most poisonous snake on this earth to me and I don’t want to go anywhere NEAR Them.

But before we get into why you shouldn’t either, let’s back up a minute and talk about what these are…

VXX is the symbol for the iPath S&P500 VIX Short Term Futures ETN, (ETN stands for Exchange Traded Note), which accesses volatility in the markets through the VIX. It is not a stock, but you may have heard it referred to as one since it can be bought, sold, and shorted -and is quoted- like a stock.

The VXX is an instrument that was created to track the first two months of the VIX (the S&P500 Volatility Index). As I mentioned above, the VIX has come to be known as the “fear index” and shows the expected 30-day volatility in the markets. It tracks the volatility indexes across the major indexes and is really used to gauge the level of fear investors have. VXX options, of course, are options you trade on the VXX (These are different from VIX options – which we’ll talk about in the future).

The VXX use what’s called a “daily rolling position,” which means that it tracks a mix of two or more months of VIX futures. It starts out as a pretty even mix between the first and second month, but as the first month’s futures approach expiration, it shifts its weight more to the second month.

Now let’s talk about why you should stay far, far away…

  1. The VXX is Cheap & Historical Pricing is Much Harder to Track

I’m not a fan of trading options on the VXX because it is cheap and is priced in the teens, as you can see on the left-hand side of the chart above.

Personally, I favor trading options on securities that are trading at higher prices than this because there’s more room for huge profits. Now you may not agree with me… and that’s fine… But my primary goal today is to talk to you about why there’s a much better way to play volatility than trading VXX options.

Say you’re waiting for the index to hit 14 so that you can buy a VXX option. Just when you think it’s cheap enough to buy the option outright, a reverse split happens…

As you know, when a reverse split happens, you end up with fewer shares at a higher price than you did before. But in the case of a reverse split on a VXX option, the price is forced higher – only to assume the downtrend once again. Take a look at the most recent reverse splits on the VXX:

Split Dates Split
2013-11-07 1:4
2012-10-04 1:4
2010-11-08 1:4

So forget about looking at a historical chart longer than a few years if you’re interested in trading VXX options… it will look like the VXX is down a lot – relative to where it’s been. And for the most part, reverse splits have to do with this.

  1. VXX Futures Prices Can Greatly Affect VXX Options

Since the VXX tracks the first two months of the VIX futures, it means those futures prices have an effect on any VXX options positions you may have…. This is similar to trading options on futures – which are extremely risky – which isn’t necessarily the place I’d want to be. Futures also don’t trade in correlation to the VIX as well as I’d like to see for such risky investments, and it’s just not worth it to your portfolio to rely so heavily upon something so risky like futures.

  1. VXX Options Run the Risk of Contango

I’ve heard some people encouraging others that want to trade the VXX or options on the VXX to do so with really short-term options because the options on the later months that are tracked are more expensive than the options on the earlier months that are tracked. This is called “contango.” Simply put, contango refers to your paying more in the future for your contract than you’re paying right now.

I’m not a fan of contango and wouldn’t encourage you to trade VXX options because contango pushes down on price. What I mean here is that volatility can go higher and higher but won’t necessarily translate into the VXX going higher. It may go slightly higher, but not as much. And when volatility falls, the VXX could fall even further.

Now, if you’re thinking “just buy puts,” keep in mind that contango is already priced into the options, making them more expensive. And if they’re more expensive, you’re going to face a bigger challenge when it comes to profiting from those options going forward.

Your Better Course of Action for Trading Volatility

When you want to play the volatility in the markets, consider trading options on the SPDR S&P 500 Trust ETF (NYSE: SPY) instead. These are two ways you can play it:

  • Consider taking a bearish position on the SPY if you think volatility will rise, causing the markets to fall.
  • Conversely, consider taking a bullish position on the SPY if you think volatility will fall, causing the markets to rise.

This strategy is much more correlated to volatility -and you’ve face much less risk. And there are just too many other – and better- options out there to choose from… pun intended.

And I don’t know about you, but I’d much rather focus my attention on prospects where making money is much more attainable.

Here’s Your Trading Lesson Summary:

Volatility is on the rise, causing more and more traders to play the VIX. But there’s special type of options play that traders are using to profit off of investor fear in the markets. Here are three reasons why you should stay away:

  • It’s harder to track the historical pricing of these options
  • Futures prices can greatly affect your current options
  • You face the risk of contango when trading these options

Until next time…

Good Trading,

Tom Gentile

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