Markets are not always as volatile as they have been in recent years. The market oscillates between two states: high volatility and low volatility. During periods of high volatility, the VIX frequently stays above 20 and rarely stays below it for long. During periods of low volatility, the VIX frequently stays below 20 and rarely stays above it for long.
In this article, I will briefly touch on the ways to trade the VIX and spend most of the time discussing high probability trade set-ups given the typical range of the VIX in a low volatility climate. This strategy is for aggressive short-term traders. Long-term, passive investors who want to know the implications of a low volatility environment should reference my last article.
How To Trade the VIX
The VIX cannot be traded directly, because it's a calculation. However, there are a number of derivatives and ETFs designed to trade movements in the VIX. (Note: Before investing or trading in any of these instruments, it's important to learn how they operate and what underlying they represent, because these instruments rarely track spot VIX, which is what most people hear about in the media. This topic is beyond the scope of this article.) As a starting place for more research, here are a few ways to trade volatility.
The best way to trade spot VIX is to buy options on the VIX, which are available on some brokerage platforms. A call option will be a long bet on the VIX and a put option will be a short bet. This is the preferred method, but options are a much more complicated product to trade.
Several ETNs and ETFs have been introduced to trade VIX futures. VIX futures are not the same as spot VIX.
Here are some popular long volatility ETNs/ETFs, and there are many more than this:
- iPath S&P 500 VIX ST Futures ETN (NYSEARCA:VXX)
- ProShares Ultra VIX Short-Term Fut ETF (NYSEARCA:UVXY)
- VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX)
Here are some popular short volatility ETNs/ETFs:
- VelocityShares Daily Inverse VIX ST ETN (NASDAQ:XIV)
- ProShares Short VIX Short-Term Fut ETF (NYSEARCA:SVXY)
These instruments are highly correlated to spot VIX, but on occasion will deviate due to the nature of futures contract rollover or other phenomena associated with volatility. Here is a chart showing 5 day correlation of spot VIX to these VIX futures instruments. A value near 1 means they are almost perfectly, positively correlated. A value near -1 means they are almost perfectly, negatively correlated.
For the most part, the long bets rise and short bets fall in tandem with spot VIX, so they can be decent proxies for trading volatility in the short-run.
Next, I will discuss data that will be used to craft a trading strategy.
Probability Density of the VIX in a Low Volatility Climate
Under the assumption that the market will remain in an extended period of low volatility, it would be useful to examine some statistics about how the VIX tended to move historically during these periods. The simplest way to express this visually is through a probability density chart. I used VIX (New Methodology) closing values from March 12th, 1991 to December 31st, 1996 joined together with October 3rd, 2003 to July 25th, 2007.
Each bar is the percentage of occurrences for each level of the VIX. For example, a VIX value of 12 (which should be interpreted "between 12 and 13") occurred roughly 16% of the time. Adding the sum of all the probabilities for each VIX level between 9 and 23 will total 100%. The higher the bar, the more often the VIX fell in that range.
- The "anchor range", meaning the range in which the VIX spent the most time compared to other ranges, was between 11 and 13. The VIX naturally gravitated towards this range over time.
- There is an unusual spike between 16 and 17, which tells me the VIX typically rose to that level and fell back into the anchor range.
- Values under 11 were extremely rare.
- Values over 17 were extremely rare.
- This particular density function is positively skewed, meaning lower values occur more frequently than higher values. The implication is that a trader should expect to make more and spend more time on the short side than the long side of a volatility trade in this environment.
Now, let's look at some descriptive statistics. The most important piece of information here is the mean value of 14.31, which can be used to create a mean-reversion strategy. The mode is 11.65, which is the most frequently occurring value in the data set. That confirms roughly where to find values in the anchor range.
The exact trade entry set-ups can be shown visually using a cumulative probability plot. The highest risk-reward ratio occurs when the cumulative probability starts to flatten.
The VIX did not stay too long below 12 or too long above 16 according to this chart.
All of this data can be used to craft a mean-reversion strategy for trading volatility. Option traders can also use this data to pick out reasonable strike prices for calls and puts. I would suggest trading volatility in this way going forward:
- Short at 16 or higher, with an exit below 13 to capture the reversion to the anchor range between 11 and 13.
- Long at 12 or lower, with an exit at 14.31 or higher as a straightforward mean-reversion strategy.
The VIX can be considered extremely low under 11 and extremely high over 17. The anchor range between 11 and 13 is where the VIX will naturally gravitate towards over time. As of this writing, spot VIX is at 11.83, right within the anchor range.
If my assumptions are correct and the market is in for an extended period of low volatility similar to what happened from 1991 to 1997 and 2004 to 2007, then these strategies should work quite well. This strategy will work until we enter the next high volatility era, which will be triggered when the 10 day average of the VIX climbs above 20 for more than 6 months. The market could enter a new high volatility period at any time. Historically, low volatility markets can last as long as 5 years.
As always, for short-term speculative trading, use small position sizes and keep your risk contained. Paper trade a strategy before implementing it. Pick an amount to trade you can stand to lose when you're ready to implement it and let the strategy reward or punish itself. Don't add new money to it; reinvest some of the profits if it is consistently successful.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.