Seeking Alpha
Profile| Send Message|
( followers)  

So You Want to Trade Volatility?

Not a day goes by on Stocktalks at Seeking Alpha without someone asking how to trade volatility, what products are best to trade with or why the volatility products in the market are not matching the moves in VIX.

As with any trade that one is thinking about entering, it is important to know what you are trading. Call it following the Peter Lynch principle, "Trade what you know," albeit very loosely. Therefore anyone thinking of trading the Volatility Index (VIX) must first be able to answer this question.

What is VIX?

VIX is the Volatility Index for the S&P 500 (SPY), a measure of how volatile the market believes the next 30 days will be. Anyone quoting the price of VIX is actually relaying a measurement of future expectations. VIX is not the perceived value of a collection of companies or the current price of a commodity, it's basically the output of a mathematical equation based on the perceived future.

The level of VIX on any given day, known as spot VIX, is a measure of the expected move in the S&P 500 in the next 30 days, annualized. So, if you see the VIX at 15.00, that means the market is currently pricing in a move of 4.33% within the next 30 days. Take whatever the spot VIX is, divide it by 3.464 and you get the percent move that the options market is pricing in for the future.

Notice that I did not say that the move would be up or down. The VIX level is simply a prediction of a move that can go in either direction. While many refer to it as the fear gauge or the fear index, it could just as easily be considered the hope index because it is just predicting a move without regard to trend. It is true that VIX spikes tend to occur when the market crashes, but that is simply due to the escalator up / elevator down nature of today's markets. The more violent the move that is expected to take place, the higher the VIX.

When you look at a chart of VIX, you are looking at the expectations for the next 30 days on for each point on the graph. Since future expectations can vary from minute to minute and headline to headline in today's markets, it is unsurprising that the VIX is, well, volatile.

How Do I Trade VIX?

Since VIX is simply a measurement of market expectations, you can't outright buy it on any exchanges. You can't readily buy and hold the output of a mathematical equation, buy you can definitely trade it. Here are the main methods of doing so:

VIX Futures

The biggest avenue for trading VIX, the one that all exchange traded VIX products are based on, are Futures contracts traded on the CBOE Futures Exchange. While understanding the Futures market is key to successfully trading volatility, I will not delve into trading actual Futures contracts and focus instead on tools that anyone can use to play VIX.

VIX Options

While one cannot buy and sell VIX outright, one can trade options on it. VIX options trade off of the spot VIX level and any trades made are a bet on the direction that the volatility index will take within the option's time frame. If you wish to trade spot VIX, this is the main avenue to do so. VIX options trade like options on any stock, except that they expire on Tuesdays instead of Fridays.

VIX Exchange Traded Products

Whether it is (VXX), (UVXY), (TVIX), (XIV) or any of the other volatility products, none of them trade based on the spot VIX price. This is a critical point to understand. If you want to make plays on the spot VIX price, VIX options are really the only way your average investor can go about doing it. Everything else on the market is trading VIX futures.

What do I mean when I say they trade on VIX futures?

Let's take VXX, for example, which is based on the performance of the VIX futures in the short term. If we are in May, VXX's performance is being determined by the performance of a mix of the June and July VIX futures contracts. Regardless of what spot VIX is doing, if the market believes that there will be more or less volatility in June and July that is how VXX's performance will be determined.

Before entering into any trade in VXX or similar product, make sure to check the VIX Futures from CBOE

What's The Big Deal?

The most recent example of why the spot vs. futures difference is so important can be seen in what happened to VXX in the last few months.

Let's start with some charts.

(click to enlarge)VIX 4 Month Performance

(click to enlarge)VXX 4 Month Performance

Above are charts for spot VIX and VXX performance in the last 4 months. These charts are a great way to show the difference between trading spot VIX and VIX futures. On the first day of the graph, spot VIX closed at 20.91. On the last day it, closed at 19.89, meaning that in 4 months spot VIX has only declined 4.8% VXX, in the same time period, has declined from 31.49 to 17.48, a whopping -44.5%. What a difference.

Where does the disconnect come from, you might ask? From the fundamental nature of trading Futures contracts. Since trading Futures is all about predicting the future, hence the name, VIX futures contracts are bets on the volatility levels that will be seen in coming months. Since the VIX itself is a bet on the future, it can get pretty confusing. I think Doc Brown would be needed to discuss all of the details. Anyone trading volatility using the futures based products needs to understand two words: Backwardation and Contango.

Backwardation

Futures contracts are always varying between being in Contango or Backwardation.

Backwardation is when the price of future month contracts is lower than the current month price. If we are in May and spot VIX is 20, VIX futures are in backwardation when the June and forward contracts are below 20. The lower the June, July, etc. contracts are in relation to the spot price, the more severe the backwardation.

Let's say VIX is in backwardation with spot VIX at 20, June futures at 19 and July futures at 18. If in June spot VIX moves to 20 and July futures to 19, anyone long VXX will have gained with the passage of time. As long as spot remains elevated above future months and they move up to meet it, VXX, or any other futures based product, is going to continue going up.

VIX in backwardation relies on the belief that the future will be less volatile than the current situation and that as time passes volatility remains or increases. This is not the norm, VIX is in backwardation only 30% of the time.

Contango

Contango is when the price of future month contracts is higher than the current month price. If we are in May and spot VIX is 15, VIX futures are in contango when the June and forward contracts are above 15. The higher the June, July, etc. contracts are in relation to the spot price, the more severe the contango.

The natural state of VIX is to be in contango. 70% of the time, VIX is in this state and as such, one must realize that VIX futures-based products are not long-term holds. Since the products move from contract to contract, always a mix of 1 month and 2 month out futures, over time, the contango will destroy any value, as the futures prices decline to meet the lower spot VIX. Don't expect to retire by holding VXX or UVXY for the long haul.

If you want to know what VIX being in severe contango does to anyone holding VXX, look at the time period between January and March in the above charts.

Rules of the Road

Now that we have the basics of trading volatility products down, let's set some ground rules for trading volatility products.

1) Always Check The Futures

Before entering any size long position in VXX or equivalent, make sure to check on the prices of spot VIX vs. future month contracts. If VIX is in contango, avoid situations where the difference is large unless making an extremely short term trade.

Make sure to be aware of when the VIX futures contracts expire. As we get closer to an expiration date (always a Wednesday) all of the volatility products will be changing the mix of their contracts to the next month out offering, which could drastically effect your trade. Use March 2012 as an example of what can happen when the gap closes and futures head toward the reality of spot VIX after contract expiration.

2) Trade Both Ways

Since VIX is in contango 70% of the time, you will want to be able to capture that downside as profit. Enter XIV. XIV is an ETF that attempts to capture the inverse of the moves in VIX futures and as such benefits greatly when VIX is in contango.

(click to enlarge)XIV 12 Month Performance

Taking a look at the 1 year performance of XIV and you can see what impact contango has on inverse VIX products.

Spot VIX peaked in October 2011 at 45 and has since fallen to ~20 (-55%). In that time XIV went from 5 to 11 (+120%). Quite the performance for a product that is supposed to be matching inverse moves in VIX. The key to the feat is the contango seen in the VIX futures between then and now. As discussed earlier, contango is cruel to anyone long volatility but is a boon for anyone playing XIV long.

Before throwing everything you have into XIV make sure to look at the performance of XIV for the whole year. Even though spot VIX now is higher than it was this time last year, XIV is almost 50% lower over the same time period.

Since VIX backwardation can hurt XIV just as much as contango does VXX, all of these volatility products should be treated as levered ETFs and not put in your portfolio as a long term hold. XIV can head to 0 just as easily as VXX and TVIX so don't expect to hold XIV forever.

3) Determine The Range

VIX generally trades in a range. Since it is simply a measure of future expectations of volatility, it could go to 0 and technically has no ceiling but in reality things are a bit different. Since its inception in the 90s, VIX has found a bottom at 9 and an all time high of 89. It has generally followed two trading ranges:

Goldilocks (Spot VIX at 10-15, 1992-1997, 2004-2007) and Crisis (Spot VIX at 15-20+, 1997-2004, 2007-Now)

(click to enlarge)Spot VIX Trading Ranges Since Inception

Once you have determined what Range the market is trading under, you can time your entries with something approaching confidence. If you have the desire to make longer term volatility trades, making entries at the extremes of these ranges should pay off handsomely.

As stated earlier, VIX is not just an indication of fear in the markets. This can be seen on the graph as 1997-2000 is a great example of when VIX was elevated but the market was screaming up.

4) Don't Be Afraid To Go Short

Since all of these volatility products trade like levered ETFs, and levered ETFs have a natural tendency to head to 0, going short XIV and VXX (and UVXY/TVIX if your broker has shares to borrow) can be extremely lucrative.

When volatility spikes, unless it is TEOTWAWKI, shorting volatility products is a fairly safe trade once the band aids have been applied and the healing has begun. The spike will subside, and then contango will kick in. Simply allowing contango to eat away will gradually flow profits into your position, barring further spikes. As with all trades in volatility, make sure to monitor the futures and avoid being caught on the wrong side of contango/backwardation.

Trade Ideas

Now that we have established some ground rules, we can get into the good stuff and talk trading ideas.

Currently, I am on the sidelines of the volatility fight. With Spot VIX at ~20 and front month futures extremely close in price, the chance of VIX entering backwardation on a market panic is high, favoring a long VIX position.

My target of choice for this trade is going to be XIV.

Spot VIX is at 19.89 now with June futures at 20.10 and July at 21.80. XIV is a mix of June and July contracts by now, so we'll estimate its price around a VIX future equivalent of 20.95 (half June / half July). If VIX were to collapse down to 15 again and front month futures keep the same premium, futures would be down at 16, 23% lower than they are now. Converting that move to XIV and we get a ceiling based on current futures structure at 13.74. Anything higher than that and we are entering Goldilocks territory, forcing the entire trading thesis to be rethought.

I believe we are trading in the Crisis Range and headed for a volatile summer so a spot VIX target of 15 might be a bit low. Take the target down to 17 and we end up with a XIV target of 12.74. I already missed out on a move from 12.40 to 10.90, so I will plan on starting a short position at 12.25 and building it up if it moves higher.

Source: So You Want To Trade Volatility?