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"Float like a butterfly, sting like a bee"

-Muhammad Ali

Continuing on from my first volatility article, today I want to delve into the method that I use when trading volatility, inspired by the above boxing legend.

First off, get rid all notions of "investing" in volatility. Volatility is volatile and the very nature of most of the VIX products makes it a losing game to try and manage a holding period beyond a couple weeks or a month at most.

Don't believe me? Take a look at the following charts for VXX, UVXY and TVIX:

(click to enlarge)VXX 2 Year Performance

(click to enlarge)UVXY 1 Year Performance

(click to enlarge)TVIX 2 Year Performance

Well, you say, that just means I should be buying inverse volatility plays by the handful. Not so fast, I say.

(click to enlarge)XIV 2 Year Performance

Even with spot VIX trading in a range from 15-20 and constant contango benefiting XIV holders, the spikes and VIX backwardation that we are seeing year after year turns inverse plays into just as risky as long volatility vehicles.

You have to remember that if XIV loses 80% of its value like it did in 2011, it takes a 500% gain to counteract it. The fact that XIV is almost recovered from the losses of last year does give credence to having a longer investment window after a spike, but it is still not a "buy and forget" investment. Investing in my mind is something I can hold for decades in an IRA, so my "investing" time frames are completely unsuitable for these short term VIX vehicles.

There are other products on the market that attempt to capture the volatility without the contango damage, but that is for future articles. Sorry.

Hopefully those longer term charts show you that long time frames for any of the short term volatility vehicles (VXX, XIV, UVXY, TVIX) need to be avoided. Just realize that the futures behind the products introduces further volatility into an already volatile trading product and put your long term money elsewhere.

Chart Spam Accomplished, Now What?

So if long term investing is out, what does that leave us? A short term and day trader's paradise!

Trading in volatility can be extremely lucrative. Anyone lucky enough to be holding TVIX in July of last year was rewarded with a run from 15 to 110 in 3 months. Those type of gains can make anyone excited about trading volatility. The move from 110 to now under 4 should be enough evidence to anyone thinking of trading volatility that the gains can evaporate and traders benefit from following a set of rules when structuring their trades.

The rules I have developed in my volatility trading experience (Inspired by the prettiest boxer ever):

  1. Wait Until You See The Whites Of Their Eyes
    1. VIX can always go lower. Wait until you start to see a slowdown whenever the VIX is trading down and look for bottoming action before dipping your toe in. You may miss out on some upside but the key is getting the direction right.
    2. b. If you get in before the direction has been established, the contango will just chop up your position while you wait for the market. Contango is a volatility long's mortal enemy and should be avoided whenever possible.
  2. Don't Chase
    1. Unless we are headed for a repeat of 2008 (Banking Crisis), 2010 (Unexpected EU Crisis) or 2011 (US Debt Downgrade) that will functionally break the markets, do not buy any long VIX product with spot VIX above 20 if you missed the initial run up.
    2. If we really are headed over the edge, there will be ample time to get long volatility. A breach of 30 in spot VIX would be my trigger to be long again if I missed the first run up. Using that as the trigger would allow me to avoid chasing minor events like we saw in May/June.
  3. Be A Scaly Monster
    1. Scaling into volatility positions is a good way to be consistently profitable with volatility trades. By dividing the total amount of money that you want to invest in the trade into different entries, it allows you to weather the stormy seas of volatility and come out with a profit on the other side.
    2. Whenever making a volatility trade with a time span of more than 24 hours, you have to realize that the trade can move against you and should size your entries according to the level of volatility in the markets
      1. Spot VIX 20+ - Avoid new positions unless we are in a true meltdown.
      2. Spot VIX 18-20 - I would still avoid positions here unless some calendar based events or economic news justifies an entry. Any entry here should be small.
      3. Spot VIX 16-18 - Gravy place for starting volatility trades. Starting here is recommended with 17.50 being the main entry point. Beware of downward trends though, if VIX is in a strong downtrend, wait until you start seeing a slowdown before starting, even at this level.
      4. Spot VIX sub-16 - This is where most volatility traders should be approaching full size in their volatility trades especially on a breach below 15. It is true that spot VIX has gone as low as 9 in the past but that was an entirely different trading environment. Since all of these trades should have a holding period measured in weeks, we should be able to expect a floor in Spot VIX in the 15's or high 14's at the worst.
  4. Set Loss Limits
    1. When sizing your trades and timing your entries, think of the trade as a whole. What is the total size of the trade? What loss would force you out of the trade according to your risk principles? Once you have that number, you can construct a trading plan with entries based on levels in VIX. Doing this will allow you to leave room to double up on the dips and increase your odds of creating a profitable trade.
    2. Once your loss limit is reached, abide by it. This will help you avoid any trips into the sub 14 Goldilocks market periods and preserve your capital for future trades.
  5. Protect Your Profits
    1. Once your trade turns profitable, set a stop at break even. Sure, you could get stopped out before a large run up but at least you will be able to sleep at night, a rare luxury when trading volatility.
    2. As the VIX increases and your trade profitability increases, move your stops up accordingly. You are trading one of the wildest bucking broncos on the market and you need to realize that your trade can turn on a single headline. You don't have to time it exactly, but for every point VIX goes up your stops should be moving up as well.
    3. Seriously consider taking out the principle or the whole trade once spot VIX hits 20. Since VIX tends to trade in a range, any pop above 20 requires exceptional circumstances that tend to be rather short lived. Use the 30 level as another buy in marker and you should be able to continue to benefit even during times of extreme market volatility.

So, that is my basic philosophy on trading volatility products. I try to emphasize being nimble and having a plan before entering any trade with volatility products. The "Protect Your Profits" rule will more than likely cause a few "Trade that got away" scenarios but that is better than the alternative of losses.

There will always be more opportunities to trade volatility. If you remain nimble, respect your stops and size your trades appropriately anyone can be successful while trading volatility.

Source: So You Want To Trade Volatility: The Muhammad Ali Method