How Can I Lose Doing This Trade?

[tmhkick01 10]

Let me start by saying I am fascinated by how poorly ETF’s and ETN’s try to synthetically mimic anything traded on the futures market. Due to rolling front month contracts into the further out month contracts and the contango that comes along with that these ETF/ETN’s do not really do what they were created to do. For example, if you look at a 1 year chart of the VXX and compare it to the ^VIX you will see that the VXX is down 60% while the ^VIX is up 20%. I understand the spot VIX and the futures VIX may be slightly different but this is still quite an extreme.

 

When looking at a 20 year chart of the VIX it appears it has always been somewhere between 10 and 45 with the one exception of hitting 80 during the crash in Oct. 2008. That would lead me to believe that theoretically the VIX has to trade in this range and would never go to zero or be able to go much higher than 80 unless the end of the world is truly at hand.

 

With all this said the trade I am thinking of putting on is shorting the VXX then selling put options at or below the current price of the VXX to create some monthly income. If after a month there is more volatility and the VXX is up at least $5 then I will short another chunk of VXX and sell more put options. If I set aside 4 or 5 equal chunks of investing capital for this trade then I can dollar cost average into it if the volatility shoots way up over 4 or 5 months and continue to sell put options against the amount I am short in the stock. Since volatility cannot stay high forever usually droping within a couple months I do not see how I could possible lose in this trade. I understand that my trading account would need to have more funds in it to cover my margin requirement if it shoots up.

 

Anyone’s input on this trade would be greatly appreciated. If my logic is badly flawed or I overlooked something I would love to hear how and why this trade does not make sense. I still cannot figure out how long term I could possible lose with this trading strategy if there is a ceiling on volatility.

 

Thank you!

[Marnie Jazmyn 10]

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value.

Edited June 28, 2010 by TLAdmin
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[james_gsx 16]

Out of curiosity, did you trade options when the vix was at 45, or 80 for that matter?

 

If I assume you already have a sound understanding of options, then I think you may already know where I'm going with this.

 

If not, then I suggest you look into how volatility can play a significant role in the pricing of options. The simple strategy to sell more puts because there is a "ceiling on volatility" could quickly erode your capital base.

[tmhkick01 10]

I did not trade vix options when the vix was at 45 or 80. I am no expert so forgive me as i don't fully understand where you are going. I would assume as volatility increases the implied volatility of the VXX options would increase making the price of the options higher as well. This would seem to play into my strategy quite nicely since i would be selling put options. Keep in mind that i am not selling naked puts as i would be shorting the same amount of stock compared to the amount of puts i am selling. I would think selling a covered put would increase your capital base since you are bringing in money for the sale of the put without taking on any liability of the put since you shorted the stock at that same strike price. If you could elaborate more on your thoughts about this trade and where my thinking has gone wrong i would appreciate it.