Crash Course in Trading $VXX (by Chicago Sean)

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Let's call this week that just ended:  Week 1 of the "Education of a VXX Speculator" (a polite nod to Victor Niederhoffer).

I took some long positions in $VXX and, frankly, I was less than
enthused with the results. Would I feel differently if my trades were
wildly profitable? Probably. However, I certainly did not like the way
the product moves. It feels as though each positive chart candle has a
dead weight around its waist. Rallies quickly run out of steam with just
the slightest pause or hesitation in the S&P. I realize much of
this is due to the current contango environment. However, I don't see
this environment changing anytime soon. And when it does, it probably
won't last that way for very long.

The inescapable fact that I can't ignore is that $VXX is essentially a
decaying product. It's natural tendency (all other things being equal)
is to drift lower. And if a product just wants to trade lower, then I
should be short it, right? Yes and no.

A Long Walk for a Short Idea

A Brown Line train crosses the north branch of...With
my long $VXX position not putting out the way I was hoping on Friday
morning, frustrated, I decided to go for a walk. I'm one of those geeky
exercise walkers. No, not the speed-walking-hip-swinging kind.
I just like to walk. It's good, safe exercise and it is where I often
do my best thinking. Plus, it was a beautiful morning on the northside
of Chicago today. Not too hot.

Stopping for a sit along the north branch of the Chicago River, an idea
began to take shape. If I'm going to continue trading $VXX I need to
have a strategy that will profit when volatility explodes (as per my trading thesis);
meanwhile, protecting myself against the unstoppable drift lower in
$VXX share price. I can accomplish this by being short $VXX shares to
take advantage of its naturally tendency to melt away, while protecting
myself during the difficult-to-predict explosions in volatility which
eventually come by being long at-the-money calls (2 calls per 100
shares), thus giving my risk profile chart the look of a long straddle (see below).

this position with $VXX currently trading at $22.57 and utilizing Aug
23 calls, if $VXX continues to drift lower, my position will be
profitable at expiration anywhere below $20.00 per share. If, however, volatility explodes, this position is profitable anywhere above
$26.00. My max loss is hit if $VXX closes at expiration at the strike
price of $23. The most I can lose is the cost of the options. In this
case, $260 per 100 shares of stock.

However, these previous numbers only hold true if I don't make any
adjustments along the way. I plan to make adjustments and therefore
expect my true risk to be significantly lower.

The plan that is taking root in my head is to short $VXX stock on
significant rallies above $23. When these trades are made, I will short
enough stock to get my position back to delta neutral.
I will hold on to the newly accumulated short shares and ride them all
the way down (hopefully) to my new downside breakeven point which will
have risen thanks to the additional stock sales. When this point is
reached, I will cover my short stock and then will effectively have a
free ride on my remaining open long calls. They could expire worthless,
but my worst case is a scratch on the entire operation. However, if we
were to have another period of rising volatility, then these calls will
retain some value, and it will be pure profit from here.

Meanwhile, once I've "roundtripped" that first operation in August, I'll
then immediately begin again in September options. And then October,
etc. My thinking is, after several months of successful operations,
there is a good chance I'll accumulate a good inventory of "free" call
options that I'll be able to liquidate into any volatility spikes. And
this is where the occasional homerun will be hit. But most importantly,
losses will be minimized during unfavorable markets.

I'd love it if some of you option geeks out there would chime in on this to give your two cents.

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