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Do you have fear of contango? Does a VIX chart make your heart beat faster? Don't be afraid -- this article is going to shed light on the dark art of volatility trading, and help you construct trades that will power your portfolio to consistent profits.

VIX - The Volatility Index

Along with S&P 500 (NYSEARCA:SPY), the VIX is one of the most important and widely quoted market indices, and also one of the most misunderstood. Often referred to as the "Fear Index," the media often uses it as a gauge of market sentiment. But the fact is that it is not a gauge of market sentiment. Surveys of how investors feel about the market (like the American Association of Individual Investors) are a gauge for market sentiment and, of course, market prices themselves are the ultimate gauge for market sentiment. If prices are lower, that means that investors don't feel very optimistic. Nonetheless, the VIX is important for a very practical reason -- it puts a concrete value to implied volatility. Implied volatility is an important component of the price of an option, and all else is being equal, a higher implied volatility will make an option cost more, and a lower implied volatility will make it cost less. The VIX is calculated in real time from call and put options on the S&P 500 index. The more call and put options that are being bought, the higher the VIX will go. It is important to understand that the VIX will go up even when the market goes up if investors are buying a lot of call options on the S&P 500 index. However, the VIX tends to spike the most during times of market duress because the most popular hedging strategy for professional investors is buying puts on the S&P 500. Investment funds generally hold large positions in individual stocks, but they hedge their long exposure via the market index. It is difficult for funds to unwind their stock holdings in a falling market without pushing the price of their securities down more than they would like. As a result, when the market gets into trouble, hedge funds and mutual funds buy S&P 500 puts. Lots and lots of them. Also, let's not forget that calls and puts on the S&P 500 are some of the most liquid and highly available financial instruments in existence, and any activity there guarantees a certain level of anonymity.

(click to enlarge)

Source: Yahoo Finance

I personally like to call the VIX the Heart Beat of the market, simply because the long-term chart looks like one -- short spurts of hyper action followed by declining levels of activity and rest.

Contango And Backwardation

So how can I trade the VIX? Well, the VIX itself is not easily tradable. You can trade VIX futures, but those are generally out of reach for the average investor with a discount brokerage account. There are ETFs and ETNs that are proxies for the VIX, and most investors today use those to trade the VIX. Here is a list of the most important and liquid ones (you can find a more complete list here):

Long VIX

VXX- iPath S&P 500 VIX Short-Term Futures ETN

VIXY- ProShares VIX Short-Term Futures ETF

UVXY- ProShares Ultra VIX Short-Term Futures ETF

Short VIX
SVXY- ProShares Short VIX Short-Term Futures ET

XIV- VelocityShares Daily Inverse VIX Short Term ETN

It is critical to understand that all of these ETFs and ETNs are subject to the phenomenon of contango and backwardation, because they try to mimic the price of the VIX by buying VIX futures. Every month, the ETF has to roll over from this month's futures VIX contract to next month's futures VIX contract. The prices of futures for a given VIX level can vary based on the date of expiration of the future. When future prices are in contango, the prices of the near-term futures are lower than the longer-term futures. When futures prices are in backwardation, the prices of the near-term futures are higher than the longer-term futures.

(click to enlarge)

Source: CBOE

What does this mean in the real world? When the futures prices are in contango, the ETF is essentially selling this month's contract at a lower price and buying next month's contract at a higher price. This makes the ETF lose value when the rollover occurs, and when this is done over a long period of time, a significant loss of value can occur. On the other hand, when the futures prices are in backwardation, the ETF is now selling high and buying low. That makes the ETF gain extra value when the rollover occurs.

You can see the current shape of the VIX futures curve at vixcentral.com. Here is what the futures curve looked like on March 4th:

(click to enlarge)

Source: vixcentral.com

Clearly, the VIX futures are in contango formation right now. In fact, most of the time -- approximately 80% of the time -- the VIX futures are in contango. As a result, any ETF that tracks the VIX on the long side will tend to lose significant value over time. If you examine the performance of the VIXY against the VIX over the past year, this becomes painfully obvious:

(click to enlarge)

Source: Yahoo Finance

The VIXY has declined nearly 80% in 2012, whereas the VIX has only lost about 30%. Significant underperformance!

And vice versa, any ETF that tracks the VIX on the short side will tend to gain significant value over time. Let's look at the stellar performance of the XIV against the VIX over the past year:

(click to enlarge)

Source: Yahoo Finance

The XIV has gained nearly 175% over the past year, while the VIX has lost about 30%, and the SPY is up only 12%. Talk about a market beating return! Can you please point me to another investment that has returned 175% over the past year?

Knowing the shape of the VIX futures curve is very important when you make an investment decision with regard to volatility, and if you haven't bookmarked vixcentral.com yet, you should do it right away.

Constructing Your Volatility Trades

The key to successful investing in volatility, however, is trying to predict the shape of the futures curve before it occurs. In times of high uncertainty, like prior to and during the Lehman bankruptcy, the VIX will quickly move above the long-term average of 20. At that time, the market will assign higher values to the near-term futures of the VIX over the longer-term futures. The VIX futures curve will move from contango to backwardation. A higher nominal value for the VIX will drive the long VIX ETF up, and backwardation will be helping the price appreciation. You want to be invested in VXX, VIXY or UVXY at that time.

Once market uncertainty peaks and TV stations have officially declared the end of the world, the VIX will start to come down initially quickly, and then slowly. The VIX futures curve will move from backwardation to contango. The nominal value of the VIX will be declining, and contango decay will keep steadily adding to the price of the short ETF, giving an extra punch to the performance of the instrument. You want to be invested in XIV or SVXY at that time.

So when do you buy the VXX, and when do you buy the XIV? Reading the news is one way. Or you can use the table below. For every price level of the VIX, I have determined from historical VIX data the percentage of time the VIX spent above and below that level:

Let's examine each situation separately. Let's assume for the purposes of this analysis that you are managing a $100,000 portfolio. You have allocated 10% for volatility, 10% for commodities and 80% for your favorite stock picks (after all, we invest because we love the products and services of certain companies).

VIX Between 10 And 13

At this level, the VIX is very low. There is at least an 80% chance that it will move up. Option prices are cheap because the VIX (implied volatility) is cheap. But the VIX futures are in contango, and the market is moving steadily up. You don't want to put too much at risk, as the market can stay happy for a long time and ignore any bad news that is trickling in. If you believe that the VIX will pick up, your best return will be realized by buying calls on the VXX, VIXY or UVXY. Not only do you put less at risk, but if the VIX moves up as you projected, the price of implied volatility will rise, adding to the intrinsic value appreciation of the option. Buy $1000 worth of calls on the VXX, VIXY or UVXY (UVXY is a levered ETF and will move up faster).

VIX Between 14 And 16

At this point, some bad news has started to come into the markets. The dam looks like it is ready to burst. But you are still uncertain. And implied volatility is not so cheap anymore. Buy $2500 worth of VXX, VIXY or UVXY and see how it moves. If the hell you are projecting breaks loose, wait for it, wait for it, and then book a profit when it happens. At this point, the odds are nearly 50-50 for an up or down move, so you don't want to be exposed to a quick loss on the downside.

VIX Between 17 And 22

The bad news has officially been pronounced, but the market still hasn't figured out the full extent of the damage. A lot is unknown. The government is actively working on a solution to the problem. At this point, the odds are 50-50 for an up or down move, but we know the main actors have confessed their sins and that resolution may be soon at hand. That will be positive for the market, bad for the VIX. Or the situation may prolong a little more, but either way, there is a light at the end of the tunnel. At this point, you want to put $2500 in XIV or SVXY. If the situation gets worse and the VIX spikes even more, double down and put another $2500. Eventually, the situation will work itself out, the VIX will decline below 20 and you will be sitting with a tidy profit. Time is your friend.

VIX Above 23

The news is bad, and the government can't figure out a quick fix. The blame game in Washington is in full throttle, the opposition party will use the situation to its advantage to gain power. Pundits on TV tell you to put all your money in cash; the market loses triple digits every other day. And worst of all, there is no light at the end of the tunnel. Well, the odds are at least 70% that the VIX will go down from here. And implied volatility is high, making options very expensive. You want to be selling options, not buying them. Sell $2000 of VXX, VIXY or UVXY in-the-money calls and buy $10,000 in XIV and SVXY. Time is your friend. In 2 to 3 months, you'll be sitting very pretty.

Using the above model, the 10% in your portfolio that is assigned to volatility trading will provide consistent and market outperforming returns. It will help smooth out any losses you may incur when trading your favorite stocks. At last, you have found in volatility the portfolio friend you were always looking for.

Source: The Art Of Trading Volatility