There are plenty of exchange traded products - ETFs and ETNs - you can use to trade volatility. But if the performance of these products are based on volatility futures contracts, why not trade actual volatility futures contracts directly instead?
For example, some traders will short the iPath VIX Short-Term ETN (VXX) against the VIX Mid-Term ETN (VXZ). This takes advantage of the usual state of contango in volatility futures, which I've described in a previous article.
The VXX owns volatility futures that expire in the one to two months from now, while the VXZ owns those that expire 4 to 7 months from now.
You might find, however, that bypassing these ETNs and trading the actual futures contract offers more precise trading opportunities that may be more profitable - and in some cases reduce losses.
But there are no guarantees when it comes to volatility futures or these exchange-traded products, so let's compare a couple of examples, first taking a look at what could go wrong.
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Summer 2011: Volatility goes into serious backwardation
Let's say it's August 1, 2011 and you're looking at the volatility term structure for the previous two months.
I've highlighted a couple of the specific volatility futures contracts, the October 2011 contract, which expires in a couple of months, and the March 2012 contract, which had just begun trading and expires in 7 months.
So you decide to go long 5 longer-term "Mini VIX" March contracts and go short 5 shorter-term October Mini VIX contracts against it. These MiniVIX contracts move up and down $100 per volatility point. That means your five contracts will move up and down by $500 per point.
Now this would have been about the worst possible time to bet on a volatility contango. Last summer, the European debt crisis news sent the volatility market into significant backwardation - not at all what you'd want to profit from a trade where you're short near-term contracts and long longer-term contracts.
In fact, here's what happened to the volatility term structure after August 1.
Your short October contracts rose against you by quite a lot, while your long March contracts did not compensate. So your trade performance would have looked like this:
Although by mid-October, the trade came back to a fairly modest loss of around $1025, the drawdown was as much as $7,000.
Yet if you'd executed a short VXX and long VXZ position - each at $10,000 worth of shares - your losses would have actually been worse, with a larger drawdown and a larger loss by mid-October.
Later in the year: Making the most of contango
What if things go right? Then the futures contracts might actually deliver higher profits. Here's a chart showing the volatility term structure for the two months ending December 1, 2011.
As you can see, volatility overall was in the 30s, so you might expect a normal contango to return. I've highlighted the February 2012 and July 2012 contacts.
The trade here? On December 1, 2011, go long 5 July 2012 Mini VIX contracts against shorting 5 of the February 2012 Mini VIX contracts. That would have worked out pretty well as the contango did return between December 1, 2011 and mid-February 2012.
That short February 2012 contract went down by 33%, with the long July 2012 contract losing money, but not nearly so much.
The profit from this futures trade would have been $3,500 as you can see here:
But the short VXX/long VXV trade would have only made you $1839.
Comparing the two approaches
I took a look at the hypothetical results for both approaches over the past several months. Here's a table of those results.
Note than the two hypothetical trades at the bottom of the list are still open and figures show the position value as of May 24.
The key question, of course, is how much capital is required to initiate and maintain these trades.
For the futures contracts, the margin requirement for the spread trades I've outlined here would be $125 per spread - or $625 for the five spreads. Given what could happen if the trade goes bad, and that margin requirements can change, that's probably too little. Yet allocating around $1,000 per MiniVIX spread would seem to be fairly conservative and offer a decent risk/return profile.
Given the profit potential most months, trading actual futures might be something worth considering. Even leaving aside the potential higher profits, it does offer you more precise control over exactly which contracts you use, something not possible with VXX and VXZ.
Finally, it would be irresponsible of me to suggest that anyone who's never traded futures contracts jump into something like this. So read up on how these contracts work. And just so you know, while I've traded futures contracts before, I've never dabbled in volatility futures.
Futures can be risky, but that's often because people are way overmargined. If you don't make that mistake, you might find the futures markets open up more valuable volatility trading opportunities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.