Friday, January 14, 2011

Managing Risk with a Short VXX Position

Since I am not sure how many readers review the comments section, I thought I should pass along a recent reader Q&A in post format in order to capture the attention of a broader audience. By the way, if you would like to see more Q&A in this space or have a specific question you are longing for an answer to, just hit up the comments section below.

Reader Mike submits:

With less $$ going into the VXX EFT due to other options to shoppers, in theory VXX should continue dropping in price value as well, correct?
I lost a good amount of money longing VXX over the summer, but recouped all losses and made money towards the end of the year shorting VXX. Now, I've loaded up on shorting it with even more capital and have a very comfortable % gain so far this year. I want to protect that gain, but my belief is that VXX will continue much lower allowing for even more reward.
I'm thinking you have the same thoughts, is that right?

Hi Mike,

Good questions. VXX is more of a function of the price of the underlying VIX futures than the demand for the ETP, so unlike some neglected stocks, it will not drop just because demand slacks off.

I'm glad to hear you have done well shorting VXX. In terms of protecting your gains, you might want to consider buying some VXX calls to hedge your risk in the event of a VIX spike. Another thought is to convert your short VXX position into a long XIV position. While these positions look almost equivalent on the surface, when VIX spikes, the size of your VXX short will increase, while the size of your XIV long will decrease. This has implications for position concentration and potential margin issues, etc. It also means that instead of having losses compound if the VIX continues to rise, there will be a diminution of incremental losses.

For example, assume a net position of $100,000. If VXX jumps 10% three days in a row a short VXX position will lose $10,000, then $11,000, then $12,100. On the other hand a long XIV position would lose $10,000, then $9,000, then $8,100. In only a few days, the daily losses become 50% higher in short VXX than in long XIV. The longer the increase in volatility persists and the bigger the daily moves are, the larger the difference becomes. Recall that in April-May 2010, the VIX tripled in a month and VXX doubled. You might want to walk through how you can protect yourself should something like that happen again.

It's something to think about, anyway.

Good trading,

-Bill

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Disclosure(s): short VXX and long XIV at time of writing

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