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Volatility is by its definition erratic and prone to frequent movements. Since a single headline could spike (Japanese Earthquake, US Debt Downgrade) or drop (Central Bank Intervention) the level of volatility in the markets, anyone trading volatility products must understand that losses need to be minimized. Discretion being the better part of valor, living to fight another day - use your choice of platitude, but one of the keys for successful volatility trading is getting out while the getting is good.

In a previous installment of this segment, I went over a breakdown of my approach for trading volatility and in the article you will see that I emphasize capital preservation to allow for continued trading. Anyone trading VXX, XIV, UVXY or TVIX has likely felt the sting of losses, but the successful volatility trader understands that while losses happen, catastrophic losses must be avoided through the use of tight stops and frequent profit taking.

A Brief History

When I first started looking into trading volatility last summer, I too anticipated a leak lower after July but failed to position long VIX in front of the August cliff diving. With the taste of missed opportunity on my lips, I got a few good trades under my belt in the early months of 2012 and then got in way over my head after the TVIX share issuance debacle. After seeing a profitable trade turn against me, I tried doubling down a couple times and just dug myself a deeper hole. Eventually I exited on a small bounce and vowed to not repeat the mistakes again.

When I got out, I feared that I was too early, and it turned out I was by a few weeks. My positioning could have turned to near break even if I had held on, but even then that was short lived as the European crisis eventually cooled down and volatility collapsed again. If I had tried to let it ride in the hopes of a major profit, I would be an even worse position now.

With every loss there are lessons to be learned and in this series we go over the basic fundamentals for successfully trading volatility. I go over this story to illustrate that I have been there when it comes to being on the losing side of a long volatility position and want to assist those already underwater and advise those considering a position.

Under The Sea

The ability for volatility products to quickly trap holders underwater is legendary. TVIX famously took holders to the cleaners earlier this year and UVXY has already gone through two reverse splits in under 12 months. Anyone that held onto their UVXY from the beginning of the 2012 has already lost almost 90% on the position and with the VIX futures structure still contango, that doesn't appear to be changing any time soon.

One of the most frequent comments I get from readers is what to do with a losing long volatility position. The answer to this of course depends on many different factors, but the majority of the time the best recommendation is to close the position at a loss and take it as a learning experience. I, for one, am awful tired of learning experiences but they are necessary when they force us to recognize a lack of knowledge in the product we are trading. If we don't take the time, educate ourselves and gather information, we will be ripe for more such "learning experiences" in the future.

The idea of capital preservation being key to successful trading is not a new one, but for volatility trading it really is the key. Here is a chart of the basics of why it is so hard to regain lost capital through trading.

Recouping Losses

Looking over the chart, you can see that there is a growing disconnect where the losses require outsized gains for full recovery. When you have lost half of your capital, you need to double your money just to get back to break even. Consistently identifying opportunities for 5+% is hard enough when trading, making up for large losses makes it nearly impossible.

Since the amount of available capital determines one's capacity to trade, the above chart gives you a good guide to go by when determining trade setups. Trading volatility provides constant opportunities on both the long and short sides. Since the frequency of trading can be high, with setups arriving on a consistent basis, one needs to minimize losses to be able to participate in as many setups as you can.

Different traders use different rules of thumb for setting stop losses but the above chart shows that between 5-10% is a good level to use as a decision point. Once you pass that point, the losses will make you more likely to fall into the trap of holding out for future gains. I say decision point instead of mandatory stop loss because trading is always more an art than a science. If you truly believe in your positioning, you can use that 5-10% loss as an evaluation point for the trade and then choose to increase size to lower your cost basis or exit entirely to wait a better setup. Since volatility in Contango is an unforgiving teacher, you should enter every trade with a strategy and realize that even if losses materialize from a stop loss, you have retained your available capital to profit from the lessons learned.

What To Do?

If you are already underwater in a long volatility position, you must first understand that while volatility in backwardation can lead to outsized gains, the historic gains still have limits. From low to high, TVIX gained over 500% last summer. That is simply outstanding returns, but to someone down 90% on a position there would still be a long way to go before breakeven is reached.

While anything can happen and volatility can spike on any given headline, volatility traders have to realize that the market behavior will limit huge gains in volatility to true panics. The downgrade of the US debt rating combined with a potential global recession and the EU debt crisis to give a protracted period of elevated volatility. It was not one event that brought about these returns in TVIX, VXX and short XIV, it was a combination of many compounding stories and market emotions.

In today's environment where we remain on the edge of the knife, we are still seeing a lot of confidence in market participants that the central bankers of the world will be able to plug the holes in the dike. Whether or not they prove correct in the long term won't matter if you exhaust all of your capital by holding onto a losing position, waiting on the bankers to fail. As long as there is more road available for can-kicking, stubbornness in holding long volatility positions will only lead to frustration and lost opportunities in the future.

Source: So You Want To Trade Volatility: Knowing When To Call It Quits