Looming Debt Crisis Might Turbocharge VXX

As Congress fights over managing the U.S.’ growing debt, and worries of a default rise amid the political rancor, investors don’t need to sit idly by. 

With the debt ceiling battle looming over a potential financial crisis, investors may want to consider a volatility strategy. 

The iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) moves higher and lower with the Cboe Volatility Index. The VIX reflects the implied volatility of put and call options on S&P 500 stocks.  

Options are price insurance. Implied volatility is the primary determinant of call and put options prices, and implied volatility is the price variance the market expects in the future. Market participants tend to buy options, or price insurance, during market corrections.  

Fear, Greed and VIX 

Therefore, VIX and VXX typically rise when downdrafts occur. Fear and greed are powerful emotions that drive market participants’ behavior, and the fear factor causes options premiums to rise during downside stock market spikes.  

The VIX ended 2021 at 17.22 and moved 25.8% higher to 21.67 last year while the S&P 500 posted a 19% decline. However, VXX did not fare well, falling 23.8% to $14.12 per share.  

VXX is only appropriate for short-term trading, as long-term positions are likely to shrink and wind up as fractional dust collectors in portfolios. However, nimble traders with their fingers on the pulse of markets can use VXX to hedge or speculate on sudden stock market declines that lift the price of the product that follows the VIX.

A brewing U.S. debt crisis could be a reason to trade VXX from the long side in 2023.  

Lower Highs, Higher Lows 

The Cboe’s VIX index reached a high of 85.47 in March 2020 as the global pandemic gripped markets across all asset classes and caused the S&P 500 to plunge.

Source: Barchart 

The above chart highlights the pattern of lower highs since March 2020. However, the VIX has made higher lows after falling to 8.56 in November 2017. The volatility index has been above the 10 level since January 2018 and over 15 since November 2021.  

In 2022, it traded between 16.34 and 38.93, with the high and low coming in the year’s first month. Since then, the VIX has traded within that range.  

Spikes and Simmering Down 

The pandemic-inspired high in 2020 was slightly lower than the peak reached during the 2008 Global Financial Crisis.

Source: Barchart 

The above chart dating back to 1990 illustrates two spikes in the VIX index: in 2008, when it reached a record 89.53 high; and in 2020, when it ran out of upside steam below the 85.50 level. Russia’s invasion of Ukraine, triggering the first major war in Europe since World War II, could not push the VIX above the 40 level.  

Meanwhile, lower highs since 2020 and higher lows since 2017 are a consolidation pattern that will eventually give way. The odds favor the upside at just below the 20 level on Jan. 23.  

The S&P 500 remains in a bearish trend since the early 2022 peak. A hawkish Fed, geopolitical turmoil, the highest inflation in decades and the rising potential for a recession could cause sudden downside spikes in the leading stock market indexes over the coming weeks and months.  

VXX Follows the VIX 

The 2022 performance of VXX highlights that it is a short-term trading instrument. While the S&P 500 fell and the VIX rose last year, VXX declined 23.8%.  

At $12.12 per share, VXX had $332.51 million in assets under management, and charges a 0.89% expense ratio. The ETN trades an average of over 7 million shares daily, making it a highly liquid product. 

Meanwhile, VXX is inappropriate for long-term passive investing as it is a wasting asset that declines over time.

Source: Barchart 

The above chart shows a steady decline since reaching a split-adjusted $315.36 high in March 2020 when Russia invaded Ukraine, and the VIX rose to the 85.47 level. The time decay causes VXX to experience a series of one-for-four reverse stock splits, with the latest in April 2021.  

The Market’s Problem With Our Debt 

While the war in Ukraine, geopolitical tensions, inflation and recessionary pressures are reasons enough to expect downside spikes in the S&P 500 this year, the most compelling reason could be the increasing concerns over the U.S. national debt.  

At $31 trillion in early 2023, the deficit is bumping up against the government-mandated ceiling, requiring the House of Representatives to agree on increasing the approved debt level. With a slim majority in the House, Republicans will likely challenge the administration to cut spending, and a stalemate could lead to a default.  

Moreover, the fed funds rate increased from a 0.125% midpoint in March 2022 to 4.375% in early January. The short-term rate will rise by at least 25 basis points to 4.625% at the early February FOMC meeting.  

Servicing the national debt at the $31 trillion level rose from a minimal amount in early 2022 to over $1.4 trillion, with the power of interest rate compounding working to push it higher over the coming years. Even if the government doesn’t increase the debt via spending, financing at 4.625% will push it over the $40 trillion level in only six years.  

The bottom line is the national debt and its rapid growth pose a significant threat to the U.S. economy and the stock market. Buying VXX and VIX-related products on price weakness could be the optimal approach, as volatility will likely return with a vengeance. In 2022, the VIX dipped below the 20 level three times, followed by a rally over the 30 level. 

A Trading Strategy for VXX  

VXX is a short-term product that is only appropriate for traders who understand planning and risk/reward dynamics and have the discipline to stick with a plan.  

Buying VXX when the VIX trades below the 20 level with a tight price and time stop could continue to be the optimal approach in 2023. When stopped because of a price decline or time horizon, reentering a long position will allow for participating when a VIX upside spike occurs.  

When the VIX moves higher, readjusting the stop to reflect the current price instead of the historical execution level will protect capital and maximize the profit potential.  

VXX is not a static investment product, and a passive approach will likely cause losses, while a dynamic plan could yield substantial profits when the VIX takes off on the upside.