Anatomy of a Winning VXX Call Trade

The following is a reprint of the market commentary from the September 2015 edition of The Option Advisor, published on August 27. For more information or to subscribe to The Option Advisor, click here.

As far as trading vehicles go, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) -- an exchange-traded note engineered to track a rolling 30-day CBOE Volatility Index (VIX) future -- has something of a dodgy reputation. Perhaps that's because VXX is essentially built to lose value as long as VIX futures remain in contango (i.e., VIX futures are higher than spot VIX), which is the usual state of affairs. So, under "normal" market conditions, a properly functioning VXX will decline steadily to new lows.

However, if a jolt of fear hits the market and VIX spikes, the futures curve might reverse into backwardation. And when spot VIX is higher than VIX futures, suddenly the calculations start working out in VXX's favor. In these situations, VXX can explode higher.

In other words, a successful bearish trade on VXX would seem to require nothing more than some time, patience, and a strong stomach for potential market shocks. On the other hand, executing a successful bullish play on VXX requires pinpoint timing (and in fairness, a strong stomach doesn't hurt on this side of the trade, either).

Of course, as far as trading advice goes, "get your timing right" is approximately as useful as saying "try to pick winners." In this month's commentary, we'll attempt to illuminate what, exactly, "pinpoint timing" might look like when it comes to betting on this notoriously temperamental volatility derivative.

On Friday, Aug. 14, it seemed like quite a few factors were aligning to signal an imminent VXX spike, which led us to consider a bullish call trade on the ETN. For starters, the technical setup looked favorable for a pop: VXX was consolidating around $16, an area from which it had rallied sharply on two other occasions over the past month.

Volatility was quite low at the time we were finalizing the details of this trade. On Aug. 14, VIX closed at 12.83 -- below both its 10-day and 20-day moving averages -- while 10-day realized volatility on the S&P 500 Index (SPX) stood at 10.04. VXX itself closed at 15.99, which meant the August 15-strike call we were eyeing, at an asked price of $1.05, carried almost no time premium to speak of.

However, we had good reason to think volatility might erupt in the week ahead. In addition to VXX's tendency to rally from the $16 level, options on VIX futures were due to expire that Wednesday, Aug. 19 -- just two days before the expiration of equity options. (Depending on how the calendar falls, VIX expiration sometimes occurs the week after monthly equity options expiration.) Historically, we've found that Wednesday-Friday returns tend to be more volatile in weeks where VIX futures options expire before equity options, relative to "anytime" returns. Per the table below, the average gains are bigger and the average losses steeper, with the standard deviation accelerating to 1.99% from the typical 1.26%.

Since the VXX call was to be just one of five trades in our Expiration Week Countdown bulletin, all with equal allocations, our worst-case scenario would be a loss of 20% of our investment. On the other hand, the best-case scenario would be a quick trip to our 200% profit target. Ultimately, we decided it was an expiration-week risk/reward equation that was too good to pass up.

Our VXX call recommendation went out Sunday evening, and subscribers entered the trade on Monday, Aug. 17, at an average entry price of $1.09. VXX remained generally flat through Tuesday's close, and edged only a bit higher on Wednesday.

But as the S&P 500 fell below its 200-day moving average on Thursday, VXX traded as high as $17.82 intraday -- and then gapped 5.7% higher at Friday's open. As the major equity indexes racked up daily losses of more than 3% apiece, VXX cruised to a final closing price of $20.72 for the week. By then, those expiring August 15 calls had already tripled in value. After entering the trade at $1.09, the VXX calls were closed out at $3.26 for a 200% gain.

So, in the case of this particular VXX call trade, "pinpoint timing" looked like this:

• Volatility was low, as measured by VIX and S&P 10-day realized volatility.
• VXX in-the-money calls were priced accordingly, with very little time premium.
• Our technical analysis suggested another VXX advance from $16 was likely in the short term.
• Historical quantified data on VIX/equity options expiration weeks appeared to confirm the odds of a volatility pop were higher than usual.

And with market volatility exploding even higher this week, many are now wondering what's next. Will VIX and its cohorts continue to rise, or is the volatility spike overdone? Right now, as our Senior VP of Research Todd Salamone explained in his latest Monday Morning Outlook, we'd wait for a VIX pullback below the key 23.90 level before buying into this latest decline.