I’m short VXZ to protect against volatility spikes

Author: Robert Zingale

Covestor model: Volatility Mean Reversion

The European debt problems appear to be resolving, and economic data from the US has recently been strong as well.  My portfolio strategy may change for the month of December, since the VIX futures have recently reentered a state of contango.  If contango persists, then I will replace my short VXZ exposure with a short exposure to VXX to profit from the term structure.

To protect against any possible spikes in VIX, I am choosing to primarily short VXZ instead of VXX right now, because VXZ increases less than VXX when VIX quickly spikes.  This will hopefully provide some protection against moments of hysteria in the market, while also profiting during VIX declines.  I will switch my strategy’s allocation to shorting VXX instead of VXZ if there is a long-term sustained decline in the VIX index coupled with a state of contango.

VIX Index Forecast 
Based on the VIX futures term structure and current market conditions, I expect VIX to trade between 20-45 in December.  This is the largest range that I’ve ever expected going into a month because I could just as easily see VIX continuing to trend downward as well as additional European debt worries rise up again.

VXX Forecast 
I also expect that VXX will primarily respond to changes in the VIX, which could result in a large trading range.  Therefore, VXX has a strong chance of being sharply higher or lower in December.

Current Position Rationale 
I am currently (as of 12/2) short VXZ to protect against VIX spikes while positioned to profit in the event of VIX declines.  I may go short or long short-term volatility through VXX or XIV depending on shape of the VIX futures term structure.  If shorting short-term volatility, I would then exit my VXZ position.  If going long short-term volatility, this would be in complement to being short VXZ.