Here's Your Perfect Hedge Trade?

The market may have reached a top—at least temporarily. Because of that, traders are looking for low cost ways to hedge against a correction or to set up a trading strategy if the market finds itself range-bound for a period.

The next couple of trading days are going to be crucial. Traders want to know if the smart money will swoop in and buy on the dip or drive the market even lower, but waiting for that answer could cause portfolio carnage.

One strategy traders use to protect themselves against a market that, at least for the short term, doesn’t feel like it has direction is to use the VIX. Since traders can’t buy the VIX, they turn to an ETF.

The iPath S&P 500 VIX Short-Term Futures ETN VXX is often the ETF (in this case, ETN) of choice. According to ETF Trends, VXX saw increased inflows on heavier volume this week largely due to the market’s 2 percent drop. On Thursday, the ETN traded 70 million shares—twice the average daily volume.

The chart painted a picture of an almost flawless risk/reward. Over the past year, VXX is down more than 77 percent and as the market began to feel toppy, VXX found a short-term floor. However, here’s where the perfect trade starts to break down.

First, looking at a long-term chart of VXX isn’t the way to evaluate the ETN. VXX, like all exchange-traded products tied to the VIX, isn’t tied to the spot price. Instead, it's tied to futures contracts and that introduces all kinds of variables.

Long-term investors in United States Natural Gas ETF UNG, quickly learned that as futures contracts are rolled over, it robs the fund of performance. As natural gas saw a run up in price, the ETF didn’t participate in the rally to the extent of the spot price.

Those who made the mistake of parking money in VXX for longer periods felt some pain. Take this week, for example. The spot VIX gained 23 percent but VXX was only up 11 percent from Tuesday’s close.

“Go out three months, for example, and that VIX ‘bottom’ you bought is four points above the actual VIX,” wrote Adam Warner at Schaeffer’s Investment Research.

How do you make the VXX as close to a perfect trade as possible? Use it as a short-term vehicle over a couple of days instead of a couple of weeks. If the market shows signs of pressure, use it as a short-term hedge but do not use it to wait on the future correction that everybody thinks will happen—someday.

VXX is not the only exchanged traded product tied to the VIX. Look at VelocityShares VIX Short-Term ETN VIIX or ProShares VIX Short-Term Futures ETF VIXY.