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The Fed is under tremendous pressure to keep the economic juggernaut rolling. The big political fear is a double dip recession on the eve of an election. The volatility of the stock market falls when there is added liquidity, so it must fall in anticipation of QE2 being implemented.

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) - Get iPath Series B S&P 500 VIX Short-Term Futures ETN Report is an excellent way to play the declining volatility. VXX is currently trading at $16.79. In a study of the relationship between VXX and the similar iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) - Get iPath Series B S&P 500 VIX Mid-Term Futures ETN Report completed yesterday, I found that the VXX declines an average of .39% in the next day after the ratio of VXX to VXZ rises above its 5-day moving average. The result was based on 283 instances and is a statistically significant difference from zero, with a t-stat of 2.13. The ratio is currently above its moving average.

The difference between the two ETNs is, VXX is based on the one to two month VIX futures, while the VXZ is based on the four to seven month futures. To play a declining VXX, I like the idea of a calendar spread strategy which will give us a direct play as well as time erosion going in our favor while we hold the trade.

Trades: Buy to open VXX January 15 puts for $1.25 and sell to open VXX December 15 puts at $1.10.

The net debit is $0.15.

The debit of $0.15 represents our maximum risk and is the amount of the investment. The idea behind this trade is that it will achieve its peak profit any time that the ETN price hits $15.00. From that price point, any move up or down will give back profit. So, we will set our stop profit there and exit with maximum profit when that price is touched. I estimate the probability of that price being hit at random to be about 58%, higher if I am right about the bearish outlook for VXX. Otherwise, we will exit on or before the December expiration.

At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.

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Phil is a professional options trader and contributes regular commentary to the Daily Speculations web site. Prior to trading professionally, Phil was a software developer for Dollar/Soft, a financial software company specializing in options software for equities, indexes and futures. He also wrote the book, Optimal Portfolio Modeling, which was published by Wiley Trading in February 2008.

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