Trading An Impending Crash Forecasted By LPPL

Using a starting date of 1/1/2010 and end date of 3/1/15, an LPPL model showed potential for a crash in May 2015 in the NASDAQ Composite Index. Running this analysis again by changing the end date to 4/1/15 and then 4/24/15 has resulted in a well fit model which yields a crash date of 5/20/15. The question now remains, How does one actually trade and profit from this information?

There is of course, no foolproof way to do this. The crash may not occur, and even if does, there is no way to know how large the decline will be or how long it will last. Therefore, we will control what we can. In analyzing potential trades we will think of this as buying insurance. We want the premiums to be low but the payoff to be large which suggests that we utilize options. Rather than look at options on the NASDAQ, consider options on VXX, an Exchange Traded Product based on the VIX index. Sparing much of the detail, suffice it to say that VIX moves up sharply during times of extreme negative price moves in financial markets and VXX is a proxy for this movement. Trading VIX is a large topic and would distract from the focus of this report.

In October 2014 there was a correction in financial markets and the response by VXX is seen in this chart.

VXX 10-2014

Figure 1: VXX began moving up from $30 on 10/8/14 and peaked just above $40 on 10/16/14, a 33% increase.

Let us examine option pricing for a move using the equivalent dates in September and October to our current situation of April and May. In other words, assuming an LPPL model ran on 9/24/14 predicted a crash date of 10/20/14, how would a trade have performed?

Since we know that the predicted crash date is not exact, we will give it some breathing room and look at options on VXX that expire on 10/31/14. Obviously, the most profitable thing to do would be to buy options on 10/8/14 and sell them on 10/16/14 but we wouldn’t have known that on 9/24/14. Let us look at an entry date of 9/24/14. Of course, entry is only half the equation in trading, an exit strategy needs to be in place as well: assuming a sharp positive price move has occurred in VXX, we will exit after VXX has two consecutive down days measured using the closing price. If no crash occurs, there is no exit, we will lose our entire premium paid for the calls.

VXX Close on 9/24/14: $28.29
9/24/14 Price of VXX Call with $33.50 strike expiring on 10/31/15: $1.04
10/16/14 Price of VXX Call with $33.50 strike expiring on 10/31/15: $7.88
10/20/14 Price of VXX Call with $33.50 strike expiring on 10/31/15: $3.30

Per the table above, with VXX at a price of $28.29, we will look at the calls $5 above the current price, or $33.50. They cost $1.04 on 9/24/14 and would have been sold after two consecutive negative closes for $3.30 on 10/20/14. The calls would have peaked at $7.88 on 10/16/14.

A significant amount of money would have been left on the table, however, an increase of over 3 times certainly meets the initial criteria of low initial premium and high payout. Professional traders often say it is not possible to catch the absolute low and absolute high, which can be psychologically difficult at times, but it is reality.

With regards to the exit criteria, in this case it wasn’t bad. However, VXX could have had two down days and then continued to increase to new highs. “Two consecutive negative closes” is more of a heuristic than a hard and fast rule but something needs to be chosen. Furthermore, the trading strategy was very straightforward: buy calls. Many other strategies could have been utilized that incorporated the implied volatility skews of the options across strikes and expiration dates as well as opinions for the magnitude and duration of the rise in VXX. Please note, these opinions would not be inferred from the LPPL model itself.

Back to our current time, as of this writing on 4/27/15, VXX is trading at $20.77 and the VXX calls with a strike of $26 and expiration date of 5/29/15 are trading for $0.36. VXX is quite a bit lower now than in Sept which is a function of how it is constructed (explanation). Arguably, we should not assume that a $5 move is justified with VXX at a much lower price to start with. Adjusting for this, a $5 move on a price of $28.29 is 18%, and an 18% move on a current price of $20.77 is $24.50. The $24.50 calls expiring on 5/29/15 are trading for $0.48.