Department of Redundancy Department Alert

• Posted by Adam Warner
• on April 30th, 2010

Is Fear too cheap? The Daily Reckoning says yes (believe it or not).

So what to do about it?

Conveniently, Wall Street has made fear a tradable commodity. One way to play it is through the iPath S&P 500 VIX Short-Term Futures fund (VXX). Though a mouthful, it simply aims to mimic the VIX. It started trading only this year. It’s done horribly, as you would expect given the fall in the VIX.

Yet it could be a nice play should we have another spike in the VIX. If fear should rear its head again, as it undoubtedly will, the VXX ought to prove nice insurance. More than just insurance, it could return three or four times your money, depending on the spike.

In one word, NOOOOOOOOO!

Now of course Daily Reckoning is not alone on the idea of owing Volatility in this fashion, not a week goes by without an intelligent player recommending this. I just don’t see how no one ever feels the need to spend 10 minutes learning about the product.

To refresh (again).

VIX may very well spike again. In fact it certainly will. But let’s say it happens in 3 month’s. By that time VXX will surely be lower than it is now, EVEN IF THE VIX HASN’T DROPPED. That’s because (again) the VIX futures markets are in contango. And are almost always in contango. In order to maintain constant 30 day duration, VXX will lose a small amount of money every day as it rolls out to a higher priced future.

But let’s say, for Daily Reckoning’s sake, VIX commences it’s explosion phase tomorrow. VXX STILL won’t triple or quadruple any time soon. That’s because a VIX future 30 days out will assume any immediate blip is just that….a blip, and a future a month out will trade at an ever growing discount to cash. You’d literally need the VIX to go to like 150 and stay there for a month or two to see VIX futures do anything close to tripling. You would however solve that contango problem!

VXX didn’t exist in 2008, but VIX futures did. And they traded at major discounts to “cash” when VIX shot to it’s highs. Something like 30 point discounts in fact, for the near month. An 80 VIX is basically unsustainable, it implies a typical day will have a 5% range. Even in the throes of the ugliness it stabilized from there.  If you want to buy VXX as speculation on a lift in volatility, fine. Just keep your timeframes short and your goals realistic.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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