We will be focusing on two of my favorite ETFs:
Proshares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY)
Proshares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY)
Before beginning I want to explain that this is a strategy to use only after volatility has peaked and is in decline. You do not want to use this strategy if the S&P 500 Volatility Index (volatility) is very low, under 13, instead wait until it is at a higher level, 15-30, and you expect it to decline. If you predict worsening economic or market conditions, avoid this strategy. I will have a follow up to this article coming out on how to profit from volatility in a worsening market and/or deteriorating economic conditions using the same ETFs.
Introduction: Highlighting one specific event, we will take a look at how you can profit from this strategy. Hindsight is cheap and easy to obtain. However, using proper economic insight can help identify when history may repeat itself. The goal is to identify or correctly predict a peak in the S&P 500 Volatility Index, initiate your trades, wait for volatility to return to a neutral or low level, and then exit your positions. This is not a long-term strategy and you should plan to exit your positions about a month (maybe longer, depending on conditions) after initiating the trade.
Looking at the chart below it would seem like a no-brainer to have a long-term short position in UVXY. As we will discuss, timing is everything.
Yes, UVXY is down over 99% since inception. However, that is not the complete strategy here. Looking over the past two years there have been more than 10 events where the ETF has moved up or down over 30% in a short period of time. Politics, geo-political tensions, and market pullbacks have been the main events during this time period, not overall economic weakening. Examples of these events include the debt ceiling debates, government shutdown, the so-called "fiscal cliff", and most recently the Russia-Ukraine tensions which I will soon highlight in detail. We know that in the future the market will move up and down based on similar events or economic changes. If you predict or anticipate overall economic weakening, this is not a good strategy to use until the market is again headed in a long- or short-term positive direction. It is important to note that by using this strategy in periods of low volatility you have a high chance of investment losses if volatility spikes to higher levels. Hence, you should have patience and wait for the correct time to execute these trades.
You can directly invest in these two ETFs by purchasing or shorting shares or use options. As I previously stated, UVXY and SVXY are my favorite vehicles for this strategy. Several other ETFs exist to track the VIX futures, such as:
iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)
VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV)
Velocity Shares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX)
ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY)
These ETFs all have average daily volumes of 600k shares or higher. It is important to note that some VIX ETFs are not optionable. I have found UVXY and SVXY to be very liquid for direct trading, have moderate liquidity on short selling, and be moderate to very liquid for options trading. Being able to move in and out of a position easily is important.
Let's take a look at the history of the S&P 500 Volatility Index going back to 1990. It is important to note that UVXY tracks VIX futures and does not follow the chart below exactly. For example, at the time of writing this article, the volatility reading for the S&P 500 was 12.03 while the VIX futures stood at 14.03. Either way they are correlated so that when one moves up or down the other typically does the same. Futures are contracts to purchase shares at a future date, hence you have time value and a difference in spot price. This can also lead to contango which you should be familiar with before investing in either ETF. You can find out more about contango here. The opposite of contango is backwardation. When backwardation occurs the VIX futures' prices would be less than the spot price. You can learn more about backwardation here.
This strategy is not dependent upon the VIX futures being in contango or backwardation. Typically, if the VIX index spikes then the VIX futures will briefly (or for a period of time) enter a period of backwardation, followed by contango once the index starts falling after an event or economic condition is resolved.
S&P 500 Volatility Index 1990-Present
Each of the spikes on the chart represent an opportunity to use the strategy I am going to highlight. Right now we are in a period of low volatility. I personally believe 20 is the magic number. Over 20 for a period of time indicates something is going wrong with the market or the economy. Under 20 for a period of time and you can assume the opposite. The VIX is a fear gauge. If investors are happy, the VIX is low. If investors are nervous or scared, it is high.
The example event we will analyze is the Russia-Ukraine tensions over the past couple of months. This is where you should put on your investor cap and let the events unfold before making a decision. Wars and geopolitical conflicts do not resolve themselves overnight like government debt ceiling approvals. They tend to drag on and cause periods of increased volatility. We have two large peaks that stand out below. I have added the commentary directly to the chart for easy reading. Earlier we discussed the debt ceiling, government shutdown, and the fiscal cliff. Make sure you research those events to document and observe how the S&P 500 VIX Index reacted. You will find some events have very similar charts and others will be unique. With each event they all have one thing in common: volatility spikes up for a bit then drops back down due to improving economic conditions.
Here is the stock chart for Proshares Ultra VIX over the same period of time.
Here is the stock chart for Proshares Short VIX over the same period of time.
Strategy 1: Invest in the ETF directly through purchasing shares of SVXY or shorting shares of UVXY. UVXY shares are sometimes hard to short due to availability. You should know your broker's fee schedule and continuously monitor your margin and commission costs if you plan on holding a short position for more than one week.
Around April 14th, per the charts, there was a good opportunity to invest. Here are the results using strategy number one:
UVXY (short): Starting share price $65. Ending: $43, a profit of 33.85%
SVXY (long): Starting share price $59. Ending: $72, a profit of 22.03%
Strategy one offers less risk than strategy two and still provides an opportunity for a sizeable return.
The benefits of this strategy include managing downside risk. You can set a predetermined loss amount or ride out the volatility and hope to profit later on. Hope does not make you money, so have a game plan and know when to fold them if market conditions deteriorate unexpectedly.
Strategy 2: Invest in options using UVXY. I like UVXY because it offers more volatility as a 2x ETF. SVXY is a 1x EFT and might be a better option for you depending on your risk tolerance. A 2x ETF is built to provide two times the daily movement of an underlying asset.
So how does this data affect UVXY options prices? Again I will only use this ETF because it provides 2x the volatility. I do not recommend using SVXY with this strategy. Let's take a look at three options only for UVXY:
Option One: Purchase Jun 21st, 2014 $60 Put around April 14th. Estimated cost is $9 with an ending price of $19 (est.). Profit of 111.11%. This is a high-risk, high-reward strategy because of the short time until option expiration.
Option Two: Purchase Jan 17th, 2015 $60 Put around April 14th. Estimated cost is $26 with an ending price of $29. Profit of 11.54%
Option Three: Sell Jan 17th, 2015 $60 Call around April 14th. Estimated credit $20 with an ending debit of $11. Profit of 45%. To learn more about selling naked options check out this article.
These options strategies include very high downside risk, up to losing more than 100% of your initial investment (option three). I would recommend directly short UVXY shares over using options unless you are an advanced investor. Even then I would recommend a mix of both.
All three options charts courtesy of optionshouse.com
Conclusion: These are proven strategies you could use to benefit from a short-term spike in volatility. It is imperative that you research economic and market conditions before making these types of investments. What may appear to be a short-term spike in volatility could be the beginning of a bear market or more serious event that will cause high investment losses. We are in a historic period of low volatility. Reverting back to the 25-year S&P 500 VIX chart, you can see that it is not expected to remain this way forever.
Disclaimer: UVXY is a high volatility ETF and should be studied carefully before making investment decisions. Different market events can insight large price swings in both ETFs we discussed today. You should be familiar with those potential events before investing in this product, we covered some examples in this article but not all possible examples. During periods of increasing volatility and economic uncertainty, this is not a good strategy. Currently we are in a period of positive economic outlook which could deteriorate over time.
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.