Trading an Anticlimax

 | Oct 01, 2013 | 9:30 AM EDT  | Comments
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VXX

I'm trying to remember something. It was a long time ago, back during a big bull market, when people were getting rich -- oh yeah, now I remember. There was this thing called "Y2K" that everyone thought was going to blow the world to smithereens. All of a sudden, everyone's computer, calculator, wristwatch and toaster would stop working and the economic world would grind to a halt, and we'd end up with a 1930s-style depression, with the "D" capitalized, and 25% unemployment. The Federal Reserve was sufficiently worried that it juiced the money supply with billions upon billions of dollars. As it turns out, this wasn't necessary.

I was an officer in the Coast Guard at the time, and I actually spent New Year's Eve 1999 in the Command Center on a high-alert Y2K watch, completely missing out on civilization's biggest party of all time. What a snooze fest it turned out to be. The only interesting thing that happened that night was that Boris Yeltsin ceded power to Vladimir Putin. Then we spent the rest of the night frantically Googling "Putin."

From a market standpoint, it was equally boring. Sure, there were some computer glitches here and there, but the world did not come to an end. Not only that, but the whole thing turned out to be nowhere near as bad as people anticipated. That pretty much sums up all of market psychology: When you know something well in advance, to the point that the news channels are putting countdown clocks on television, there's a pretty good chance that the bad news has been priced in.

There are ways to trade the bad news being priced in. Implied volatility, as measured by the CBOE Volatility Index (VIX), has been rising pretty steadily going into the shutdown. That's predictable behavior -- people don't know what might happen, so they bid up the price of options for protection and speculation. People are expecting volatility in the future, and that's not unreasonable if you consider that the market tanked both after the Standard & Poor's U.S. downgrade and amid the Greece blowup. But the difference is, nobody was expecting either of those things to happen. In contrast, we've known for weeks about the potential for a government shutdown.

A good way to play nothing happening is to short implied volatility. In the old days, you'd have to be short a portfolio of options and to dynamically hedge the position, but today we have trading vehicles to express a view on volatility without all the mess of delta hedging. iPath S&P 500 VIX Short Term Futures ETN (VXX) is probably the simplest and easiest product to trade.

VXX is an exchange-traded note that holds VIX futures. Generally, it holds the front-month future and rolls a small amount to the second month on a daily basis. There are two ways to win (or lose) with VXX. Volatility can go down (or up). But also, VXX holds both first- and second-month futures -- so, to the extent that second month futures are higher, the holder of VXX will benefit from roll-down as the fund moves its position from one month to the next. Also, short-term implied volatility moves more quickly than do longer maturities, so if volatility were to get squashed after the shutdown, the effect would be even more pronounced.

I think it's actually cleaner to express this trade in volatility rather than directly via stocks. Sure, this could be a case of "sell the rumor, buy the news," but with the stock market, there are all kinds of other variables you have to worry about. I'd rather just trade pure fear or, in this case, the absence of it.

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