Trading The VIX Without Using Volatility Products

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 |  About: SPDR S&P 500 Trust ETF (SPY), Includes: TVIX, UVXY, VXX
by: Bret Kenwell

Let's be honest: trading volatility can be a sucker's game. You've either mastered it or are getting killed by it. Most have traded the levered ETFs for volatility, seeing as though you can't buy shares of the Chicago Volatility Index (VIX). You can only trade the options for it. Products like TVIX, UVXY, and VXX are all long-volatility ETF products, with many traders playing it for a downside move and investors using it to protect their portfolio.

In a perfect world, those ETFs would perform accordingly, while not constantly grinding towards $0. Unfortunately for most (and fortunately for some), these products haven't performed the way they're supposed to. They've experienced multiple reverse splits while continually declining. The decay in these products is ridiculous, making it nearly impossible to hold for more than a week or two at a time.

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However, there is a way to effectively trade volatility and take advantage of it when it gets cheap enough. Debit spreading the VIX can be an effective ploy, but I prefer to use the VIX as a guideline or indicator rather than the trading product itself. The VIX has a history, as I note on Seeking Alpha's StockTalks quite often, of not staying below $14 very often. Once this level is breached, it might stay there for a few days, but more times than not, after several trading sessions have passed, it quickly rises back to the $15-$16 range.

So if we're not trading volatility ETFs and we're not trading the VIX outright, what exactly does that leave? For the most part, I'm trading the SPDR S&P 500 ETF (NYSEARCA:SPY). It's much easier, much more liquid, and nearly just as efficient, if not more. The SPY and volatility are highly correlated, with the SPY declining when volatility is on the rise, and rising when volatility is going lower. The VIX is commonly referred to as the "Fear Gauge" with the belief that investors and traders are buying stocks when volatility is low and selling stocks when volatility is high.

The Trade

For the VIX, I can give a trade right now and a general trade for the future. Traders can do different things and get the same effect, but I prefer to use the weekly SPY options. By using the weeklies you get very high gamma, which depicts the rate in which your delta will increase or decrease. Many times, as traders have discovered, this leads to double- and triple-times gains from the original price if the trader is correct on the future price movement.

Recently, the VIX traded relatively low at just $13.98, slightly below the $14 mark. My trade to take advantage of this would be to buy the September weeklies, (which are also the quarterlies in this case, as the end of September marks the third calendar quarter of the year. Depending on your broker it may be displayed this way rather than as weekly options). I like to buy at-the-money or slightly out-the-money put options. The trade would look similar to this:

SPY currently at $145.87

VIX currently at $13.98

BUY 1 Sept (NYSE:W) 145 PUT @ .57

Net Debit: $57

In the coming days, I would suspect a drop in the overall markets, allowing the puts to pay off handsomely. This works well in general conditions. When the VIX goes below $14, I look for shortly expiring put options to capture a gain. It allows even a small dip in the SPY to move these options quite quickly. However, many should be aware, especially those who aren't familiar with weekly options and the rapid decay they possess, that these options can become worthless rather quickly.

I think it's also important to note that volatility may continue to decrease over the next several months. With so many central banks and world economies--now including the U.S. Federal Reserve--looking to do different versions of QE, equities could continue to drift and rip higher. This would allow the VIX to go lower, possibly into the $11 or $12 range at times.

For now, I will continue to trade the sub-$14 VIX until it's no longer profitable. The SPY doesn't need to fall 5% to generate a good return in options; a slight correction or day of profit taking is likely enough to do the job. Remember, when you get a move in the weeklies, big or small, it may be your only chance to take a profit, however big or small it may be.

Note: this article was written on September 23rd and time-sensitive data may have changed since.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. I am long SPY puts. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.