Is it possible to consistently make returns by trading options on the VXX ETF? If so, what is the process for doing so?

 

Trading options on the VXX ETF: path to consistent returns

 

     Trading options on the VXX ETF can be a lucrative venture if approached with a solid strategy and disciplined risk management. The VXX, an exchange-traded note (ETN) that tracks the S&P 500 VIX Short-Term Futures Index, offers exposure to the volatility of the U.S. stock market. As a product that measures market fear and uncertainty, it’s inherently volatile and carries unique risks and opportunities. However, the potential for consistent returns exists if you understand the intricacies of this financial instrument and apply the right options strategies.

 

Understanding the VXX ETF

 

    The VXX ETF is designed to follow the VIX Index, often dubbed the "fear gauge" because it rises when there is a spike in market volatility. The VIX Index reflects the market’s expectations of volatility over the next 30 days based on S&P 500 options. The VXX specifically tracks the performance of a rolling long position in the first and second month VIX futures contracts, meaning it is constantly rolling over these futures to maintain its exposure.

 

    One critical aspect to note about the VXX is its tendency to decay over time, primarily due to the contango effect in the VIX futures market. Contango occurs when futures prices are higher than the spot price, which forces the VXX to sell the cheaper front-month contracts and buy more expensive next-month contracts, leading to a gradual erosion of value. This characteristic makes the VXX less suitable for long-term holding but opens up opportunities for short-term trading, especially through options.

 

Key options strategies for trading the VXX

 

Selling covered calls

 

Overview:  Selling covered calls involves owning shares of the VXX and selling call options against those shares. The main idea is to generate income from the premiums received by selling the calls.

 

Process:

Purchase VXX shares.

Sell call options with a strike price slightly above the current price of VXX.

If the VXX stays below the strike price, you keep the premium as profit.

Advantages:  This strategy is beneficial in a low-volatility environment where the VXX is expected to remain stable or decline slightly. The premiums collected can help offset the natural decay of the VXX.

 

Risks:  If the VXX spikes above the strike price, the shares could be called away, capping your upside. This risk is partially mitigated by the premium received, but it’s crucial to choose strike prices carefully to balance potential returns with risk.

 

Buying put options

 

Overview:  Buying put options is a direct way to profit from a decline in the VXX. Given the natural downward drift of the VXX due to contango, put options can be a profitable strategy.

 

Process:

Purchase put options on the VXX with a strike price close to the current market price.

If the VXX declines, the value of the put options increases, allowing you to sell them at a profit.

 

Advantages:  This strategy leverages the predictable decay of the VXX, making it a potentially consistent source of profits.

 

Risks:  The primary risk is timing. If the VXX experiences a sudden spike in volatility after purchasing the puts, the options could lose value. Therefore, careful market analysis and timing are crucial.

 

Bear call spread

 

Overview:  A bear call spread is a conservative options strategy that involves selling a call option at a lower strike price while buying a call option at a higher strike price. It profits from a neutral to bearish outlook on the VXX.

 

Process:

Sell a call option at a lower strike price.

Buy a call option at a higher strike price with the same expiration date.

The maximum profit is the premium difference if the VXX stays below the lower strike price.

 

Advantages:  This strategy limits potential losses while providing a defined profit if the VXX does not rise above the lower strike price.

 

Risks:  If the VXX spikes above the higher strike price, the strategy results in a loss, although the loss is capped. Choosing the right strike prices and closely monitoring market conditions is vital for success.

Iron Condor

 

Overview:  An iron condor involves selling an out-of-the-money call spread and an out-of-the-money put spread simultaneously. This strategy profits when the VXX remains within a specific range.

 

Process:

Sell a call option and buy another call option at a higher strike price.

Sell a put option and buy another put option at a lower strike price.

The maximum profit is achieved if the VXX remains between the strike prices of the sold options.

 

Advantages:  The iron condor is particularly effective in a low-volatility environment where the VXX is expected to trade within a narrow range. It offers limited risk with a defined profit range.

 

Risks:  If the VXX moves significantly outside the expected range, the iron condor can become unprofitable. Adjusting the position as the market evolves is key to maintaining profitability.

 

Calendar spreads

 

Overview:  A calendar spread involves buying a longer-dated option and selling a shorter-dated option with the same strike price. This strategy takes advantage of time decay (theta) and volatility differences between the two options.

 

Process:

Buy a long-dated call or put option.

Sell a shorter-dated option with the same strike price.

As the shorter-dated option expires, the value of the long-dated option can increase, allowing for a profit.

 

Advantages:  Calendar spreads are effective when the VXX is expected to remain stable or when volatility is anticipated to increase in the longer term. They also benefit from the rapid time decay of the shorter-dated option.

 

Risks:  A significant move in the VXX in either direction can make the calendar spread unprofitable. The strategy requires precise timing and an understanding of volatility trends.

 

Risk management:  The Key to Consistency

 

Consistently making returns from trading VXX options depends heavily on robust risk management. The VXX is a volatile instrument, and even with well-planned strategies, market conditions can shift rapidly, leading to unexpected losses. Here are some key risk management techniques:

 

Position sizing:  Never allocate too much of your portfolio to a single VXX options trade. Given the volatility of the VXX, it’s crucial to keep individual trades small relative to the total portfolio.

 

Stop losses:  Implement stop losses to protect against adverse movements in the VXX. While options have limited risk compared to the underlying asset, unexpected spikes or drops in the VXX can still lead to substantial losses.

 

Diversification:  Avoid putting all your eggs in one basket. Diversify across different strategies, asset classes, and even different expiration dates within VXX options to spread risk.

 

Monitoring market conditions:  Volatility can be influenced by various factors, including economic data releases, geopolitical events, and central bank announcements. Staying informed and ready to adjust your positions as conditions change is essential for success.

 

Practical considerations

 

      When trading options on the VXX, it’s important to consider transaction costs and liquidity. The VXX is a popular instrument, so options tend to have good liquidity, but bid-ask spreads can widen during periods of high volatility, affecting profitability. Additionally, transaction costs, including commissions and slippage, can eat into returns, especially for frequent traders.

 

       Another consideration is the psychological aspect of trading such a volatile product. The VXX can experience sharp and unpredictable moves, which can be stressful. It’s crucial to have a well-defined plan and stick to it, avoiding emotional decisions during periods of market turmoil.

 

Conclusion

 

     Trading options on the VXX ETF offers the potential for consistent returns, but it requires a deep understanding of the product, careful strategy selection, and disciplined risk management. The VXX’s unique characteristics, such as its natural decay due to contango and its sensitivity to market volatility, create both opportunities and challenges for traders. By employing strategies like covered calls, put buying, bear call spreads, iron condors, and calendar spreads, traders can potentially profit from the VXX’s movements.

 

      However, success in trading VXX options is not just about choosing the right strategy; it’s also about managing risk effectively, staying informed about market conditions, and maintaining the discipline to stick to a well-thought-out plan. With the right approach, it is possible to capitalize on the VXX’s volatility and generate consistent returns over time.