Bagging in shorts on volatility

The short volatility trade we took in May and June had performed quite well, as the market went from near-panic mode, to the anticipation of the Goldilock condition once earnings season started.  While the economy may not enter into a double-dip recession, we think a Goldilock situation where everything is hunky dorry is unlikely due to the following factors:

  • Job situations have not improved and are unlikely to improve substantially given the recent cautiousness of consumers.
  • Interests rate is already at its lowest point, and yet home builders continue their bearishness reflected by the home builder sentiment index towards 3rd and 4th quarters.
  • This quarter earnings are being compared to the darkest period a year ago, and expectation has now turned higher.  Any earnings disappointment will be amplified going forward.

When we started shorting iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), it was around 30.  We had started covering the position around 24, and have now covered the full position.  If the market keeps going higher, VXX may very well move to 20, and in that case, we will consider going long on the position.

On iPath S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ), we started the short position at 95, and now it’s now ~83.  We will probably hold this short position until it moves closer to 80, as we don’t anticipate very sharp swing in the market until next earnings season.

On VXX and VXZ, we always have a GTC order to short them once they reach a certain level.  Currently the level is set to 30 on VXX and 100 for VXZ.  Nonetheless, as mentioned before, we never enter a short position, especially on volatility trade, with high leverage, so we can hold or add to the position even if volatility continues to rise.

When volatility rises, as is the case in any market panic situation, it can rise very sharply in a very short time.  When market rallies, it can also decline very quickly.  When trading volatility, this is something one always has to keep in mind.

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