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Trading a Recognizable Trend

Trading a Recognizable Trend

Trends are simple in theory but can be difficult to spot in practice. The idea is simple. If prices are generally rising, the trend is up. If prices are generally falling, the trend is down. The difficulty comes from defining the word “generally” in that expression.

Some investors simply look at a chart and determine the direction of the trend at a glance. This can be a useful technique, but the timeframe of the chart must be aligned with the timeframe of the investors. The chart below illustrates why.

Trading a Recognizable Trend

This is a monthly chart of iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) since it began trading in February 2009.

Wall Street Meets Demand With VXX

Notice when VXX began trading, in February 2009. That was just before the bear market ended in March 2009. Bear markets are accompanied by volatility. High volatility led to a high degree of interest in trading volatility and Wall Street answered that interest with volatility Exchange Traded Notes (ETNs).

An ETN is similar to an ETF. It can be bought and sold just like a stock and has low trading costs. The difference between the two is that an ETF owns stocks while an ETN owns derivatives, adding another level of risk to the investment.

A derivative is a trading instrument that is based on something else. It will always have an expiration date. On that date, the contract will spell out settlement terms. An option on a stock is an example of a derivative. At expiration, the settlement calls for delivery of stock if the option is above or below a certain price. Otherwise, the contract is worthless.

Options are traded through an exchange and are backed by the rules of the exchange. There is no risk that one party in the trade will fail to meet the settlement terms because the exchange rules ensure everyone with an open trade can meet their obligation.

Not all derivatives are traded on an exchange. Many contracts are customized, and the settlement terms are individualized. The parties to the contract set the terms and collateral requirements. There is no exchange in the middle to enforce the settlement terms. This creates a risk of default.

Default risk can be found in some ETNs. These products use customized derivatives and are usually contracts between the ETN and a major investment bank. Technically, there is a risk of default although in the bear market of 2008 and 2009, there were no defaults in any exchange traded products.

While this risk is remote, it should not be ignored. When trading ETNs, conservative investors should consider the underlying derivatives owned by the ETN. A visit to the ETN sponsor’s web site will usually provide this information.

An ETN Can Be Used to Trade Volatility

VXX is based on VIX but does not strictly track the VIX index. Its underlying holdings consist of futures contracts on the VIX. These are exchange traded futures and are therefore as free from default risk as possible for a derivative. That makes VXX an ideal choice for conservative investors seeking a volatility trade.

While the underlying assets are free from default risk, this is not a conservative investment. VXX is a risky investment and the ETN shows a long term downward bias. The ETN frequently completes a reverse split to maintain a price above $10 a share; five since 2009.

But, VXX does not move straight down. The monthly chart may give that impression but there is volatiliy in shorter time frames. The daily chart over the past six months shows this.

An ETN Can Be Used to Trade Volatility

As the chart shows, VXX tends to spike higher at times. That creates a potential trading strategy. It is possible to buy the ETN. That sets up a possible profit if the trader can sell for a gain when the spike occurs. The consistent downward bias makes that difficult to do in practice.

A Trading Strategy to Benefit From Potential Weakness

Because of the unpredictable extreme behavior in volatility, traders should consider using an options trading basics strategies known as a bear put spread to benefit from the expected price move.

This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.

A Trading Strategy to Benefit From Potential Weakness

Source: The Options Industry Council

A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.

The Trade Specifics for VXX

The bearish outlook for VXX, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.

A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive.  The risk of loss when buying an option is equal to 100% of the amount paid for the option.

To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.

Specifically, the November 17 $31.50 put can be bought for about $0.38 and the November 17 $29 put can be sold for about $0.02. This trade will cost about $0.36 to enter, or $36 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spend to open the trade, or $36. This loss would be experienced if VXX is above $31.50 when the options expire. In that case, both options would expire worthless.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in VXX, the maximum gain is $2.12 ($31.50 – $29 = $2.50; $2.50 – $0.38 = $2.12). This represents $212 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $39 to open this trade.

That is a potential gain of about 450% on the amount risked in the trade. This trade delivers the maximum gain if VXX closes below $29 on November 17 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.

Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $40 for this trade in VXX.

You can find more trades like this in the Trading Tips service, Options Cash Cow. To learn more, click here.