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By Mike McDermott

As equity markets continue to make new highs, the level of investor complacency is also rising. Despite mounting risks, higher equity prices have helped to boost trader confidence. The resulting feedback loop has propelled stock prices higher, but has done little to create a more stable economic environment.

This scenario creates an interesting conundrum for traders. With markets continuing to press higher, fighting the bullish trend can be very costly.

But at the same time, with each tick higher, the market becomes more extended and at risk for a sudden downdraft.

If an unforeseen overnight event causes a significant gap lower, it may be impossible to manage risk levels for existing long trades – not to mention setting up bearish trades to capture profits on the way down.

One way to take advantage of such a move is to have a long volatility trade in place.

The iPath S&P 500 VIX Short-Term (NYSEARCA:VXX) is one option for putting this kind of trade to work …

What is a Long Volatility Trade?

A long volatility trade is a setup that is designed to take advantage of a disruption in the market. If volatility picks up, the trade should capture profits. However, if volatility remains low or continues to drop, the trade will usually lose premium and result in a net loss.

Traditionally, traders have used various option strategies to set up long volatility trades. Option prices are directly tied to volatility expectations.

From a very basic standpoint, if a trader believes volatility will be high, he will be willing to pay more for an option contract. The higher volatility increases the payout if the underlying asset moves significantly in a profitable direction. This "volatility premium" is one of the primary inputs when calculating an expected price for an option.

A true "long volatility" trade would typically be set up without a directional bias. In other words, it doesn't matter whether the price rapidly increases or decreases … the key is for volatility to pick up.

But in the real world of trading – and especially with equity indices – volatility has a strong inverse correlation to price action. So when prices begin to drop, volatility (and expected volatility) begin to rise. The sharper the drop, the greater the increase in volatility.

Volatility and the VIX

The CBOE Volatility Index (VIX) was designed to measure expectations for volatility. The index is calculated based on the prices of a basket of S&P 100 (OEX) options. Basically, the index calculates how much premium option traders are paying for these contracts.

Higher premiums indicate traders are expecting volatility to be high. Higher premiums by definition result in a higher price for the VIX. On the other hand, if volatility expectations are low, option traders will not be willing to pay as much for OEX options – the net result is a lower index value for the VIX.

As shown in the chart below, the VIX has a significant inverse correlation to the price action in the S&P 100. When stocks enter a significant bear market, expectations for volatility rise sharply. From a magnitude perspective, the VIX has experienced very sharp price increases (many multiples of the magnitude of OEX decline).

The inverse correlation would make the VIX an excellent hedging vehicle for traders and investors. But there's just one problem: The VIX isn't actually a tradeable vehicle!

VIX and OEX - (Click to enlarge)

Once the VIX became a widely followed indicator, traders began using options on the index to hedge exposure and speculate on changes in volatility. The options were helpful, but since the VIX remained a non-tradeable vehicle, there were no arbitrage opportunities – and so the VIX options did not always trade in line with the action in the underlying vehicle.

The next step was to create futures contracts which settled based on the price of the VIX. These vehicles have become a bit more efficient and much more closely correlated to the action in the VIX. At the same time, new volatility indices for popular benchmarks such as the NASDAQ composite and the S&P 500 have evolved.

And that brings us to VXX

The Volatility ETF

VXX has become an actively traded ETF and can be used by typical stock traders and even placed in IRA accounts. For this reason, the VXX is a popular vehicle for retail investors who typically use the ETF to speculate on a sharp drop in markets, or to hedge long exposure.

The ETF offers some great advantages, but also has drawbacks that many retail traders may not be aware of.

  • Significant inverse correlation to S&P 500 – Since the VXX began trading in early 2009, the instrument has experienced positive action in periods where the S&P 500 traded down sharply. The negative correlation can be effective in offsetting traditional investment losses.
  • Magnitude of movement results in significant gains – The VXX has put up some tremendous price movements. In May of 2010 (during the "flash crash" period, the VXX rose by more than 100% in a month's time. This year, between February and March, the VXX rose 42% in comparison to a 7% drop in the S&P 500.
  • Negative Carry – Volatility Decay – Option premiums "decay" over time – or decline based on the amount of time until the option contracts expire. For this (and some other quirky statistical variables), the VXX price has a natural tendency to slide lower. This makes the ETF much more effective for short-time periods, and a negative-carry trade for long holding periods.

Knowing these facts about the VXX, traders can use the vehicle to set up an attractive "R" position. "R" refers to "Reward to Risk" ratio. So risking $3.00 by taking a long position in the VXX – with the potential to make a $18.00 profit would result in an "R" of 6.0.

Of course, traders could also short the VXX as a positive carry trade. In this scenario, a short position would benefit from the negative carry (sliding VXX price) over the long-term.

A note of caution here: The VXX tends to slide slowly, and spike rapidly. So a short position in VXX may be akin to picking up nickels in front of a bulldozer. In this case, a trader may want to have significant bearish exposure which would offset any unexpected negative action in the VXX

The VXX is an excellent short-term vehicle for hedging bullish exposure or speculating on a market dislocation. But for longer-term volatility plays, the volatility decay makes this a more difficult vehicle to work with.

(Click to enlarge)

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

Source: Using VXX to Trade Volatility