There is a very concerning strategy that is out there right now that has to do with shorting volatility products. Now, I can't argue that this has been a losing trade. Certainly times are good right now if you have been shorting volatility but just know you are playing with fire and the volatility products are probably the most misunderstood products in all of the markets.
Shorting volatility can come in many ways. One could sell call options, buy put options, trade the Vix futures or ETF's. For today's conversation we will focus on the Volatility ETF (NYSE: VXX) as that seems to be a common vehicle for most traders.
One thing you should remember is that the VXX is a fear indicator for the S&P 500 and is NOT an inverse S&P product. All too often it is taught that when the markets go down the VXX will go up and that is simply not true. Sure, if the markets have a move lower it is likely that VXX will respond bullishly but it is not a 100% guarantee.
The VXX has been lower almost every single day for months now and rightfully so. No one is very scared of the markets right now. They are not scared the markets will rocket higher and they are not scared of a severe decline. The VXX responds to this fear and thus, even on down days in the markets there is no reason the VXX should spike. This is good news for the short VXX trader right? Well yes and no. See the volatility products are like a game of musical chairs. As long as the music is playing you know there is a seat for you when the music stops, BUT WHEN the music stops you may be left out. This is not an analogy to say you will lose money it is an analogy to say you could lose the entire game and blow up.
Think of the VXX as a stock that has pending news, and that news is going to be big. What happens to stocks like that? They blast off all in one fell swoop leaving lower prices in the dust. That is great news for long VXX traders but there is such a large group that is short right now that anything that scares them out will cause even more buying! Add to that those that come over and buy VXX when they get scared and you will have one huge rally. To sum it up, don't short the volatility products right now or you may be left without a chair!