The best time to plant a tree is 20 years ago…
When we see volatility spikes in the market like what we’re experiencing now, investors start to get nervous and start asking themselves if their portfolio is hedged enough to handle a downturn.
You see, when the markets are rocking and the bulls are in charge, volatility is generally low and the cost of portfolio protection is cheap.
No one wants to buy hurricane insurance when it’s blue skies outside, right? Everyone wants to buy insurance when the storm is coming their way!
On the other hand, when we have uncertainty and fear in the market, the demand for insurance increases, and in turn, pushes volatility higher.
There are a slew of volatility products that traders and investors can use to either hedge their portfolio, or even speculate on what volatility does next. That said, if you’re new to volatility products you’ll want to pay attention, and educate yourself first before diving into this wild and potentially lucrative space.
Now, I can’t guarantee you’ll have results as good as this… but even if you never end up trading a volatility product, I can promise you that it will help improve your decision making when it comes to making market calls.
Making Sense of Volatility
You’re probably wondering, “What’s the secret to trading volatility and the overall market?”
First, you’ll need to understand how the CBOE Volatility Index (VIX) works.
Now, the VIX – also known as the Fear and Greed Index, measures the 30-day expected volatility of the market, using mid-market prices of S&P 500 Index calls and puts. When VIX remains at elevated levels, it’s an indication traders are expecting increase volatility in the short term. On the other hand, when VIX is near the low-end of its range, the market is in a low-volatility environment.
Well, one secret indicator to trading volatility is the VVIX Index (VVIX). The VVIX measures the “volatility of volatility”. You could think of it as the expected volatility driving the price of the CBOE Volatility Index (VIX) near-term options.
Take a deep breath, and just think about that for a moment.
That in mind, if the market is experiencing some volatility, I watch this indicator as a gauge to see what traders expect the VIX to do in the future.
Don’t worry if this doesn’t click at first, just follow along with me.
Check out this daily chart of the CBOE VVIX.
If you look at the chart above, you’ll notice a blue horizontal line. This is the 120 area, and it’s often thought of as the “line in the sand” for this index. In other words, when VVIX spikes above 120, chances are it won’t stay above that area for long.
Notice what happens when VVIX falls below 90 (the purple horizontal line)…it doesn’t stay there for long.
It’s that simple.
Now, if you look at the chart of VVIX, in early October, VVIX spiked above 120, hitting a high of 147…however, just a few days later, it fell all the way back down to 109.
Strategy for Volatility Trades
That said, when the VVIX is approaching 120, I keep it on my radar. Now, if it breaks above that level, I typically want to sell out-of-the-money (OTM) calls on VXX and collect premiums since VVIX never holds that level long. Now, if you don’t understand options trading or strategies, make sure to check out this guide before getting into any options trade.
On the other hand, when it is drifting lower, I want to be a buyer of stocks in general. If you see gradual fade in VIX and a gradual climb in SPY, that is one of my favorite setups. However, when you see VIX start to go against SPY then it is time to reverse the trade.
Here’s what I’m talking about…
Notice how the VVIX (the chart on the top) is in a down trend. However, the SPDR S&P 500 ETF (SPY) is right at support. This is a scenario where I would consider buying stocks.
However, there’s one more thing you need to understand about volatility products – which exchange-traded funds (ETFs) or exchange-traded notes (ETNs) to trade.
Volatility-Tracking Exchange-Traded Products
Here’s a look at a list of volatility products.
|iPath S&P 500 VIX Short-Term Futures ETN (VXX)||S&P 500 VIX Short-Term Futures Index Total Return|
|iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB)||S&P 500 VIX Short-Term Futures Index Total Return|
|ProShares VIX Short-Term Futures ETF (VIXY)||S&P 500 VIX Short-Term Futures Index|
|ProShares Ultra VIX Short-Term Futures ETF (UVXY)||S&P 500 VIX Short-Term Futures Index (1.5X daily performance)|
|ProShares Short VIX Short-Term Futures ETF (SVXY)||S&P 500 VIX Short-Term Futures Index (-0.5X daily performance)|
Now, there’s one thing you need to understand about volatility products…they’re naturally going to lose value over time due to compounding of daily returns. That said, it is never something to put in your portfolio and forget about it.
Moreover, volatility products are designed to track the one-day performance of their respective underlying indices, or benchmarks.
For example, if you’re long VXX, and the underlying index spikes up 3%, VXX should be up around 3%. However, if you hold it for longer than one day…then your expected returns for VXX would not necessarily match the index’s performance over the day period.
That in mind, volatility products are best suited for short-term trades.
There are a few things to note about the table above: UVXY is a leveraged product and should not be used by beginners.
If UVXY’s underlying index falls by 5% one day, then the ETN should be down 7.5% that day. You could see how this could be dangerous is the S&P 500 VIX Short-Term Futures Index drops by 20% in a day…
Moreover, VXX will cease trading on January 30, 2019, and VXXB will trade in parallel to VXX until that date.
These volatility products are unique and offer so much opportunity you can either trade the underlying or with options. Now, if you’re looking for a good primer on options check this out (and yes it’s free).