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Through this article, I will describe how to profit from a VIX ETF, by trading it both over the short and the long term. This ETF is the Proshares Ultra VIX Short Term Futures ETF (NYSEARCA:UVXY), more widely known as UVXY, which is its ticker.

The VIX- An Introduction

The VIX was created by CBOE in 1993 and is often referred to as the "investor fear gauge". It shows the market's expectation of 30-day volatility using the implied volatilities of a various S&P 500 index options- including both calls and puts. A widely used measure of market risk, VIX values greater than 30 represents a market with a large amount of volatility as a result of fear or uncertainty, while values below 20 generally represent a less stressful or even a time of complacency in the markets.

The UVXY- The ETF's Introduction

The UVXY seeks a return that is 2X the return of the VIX in a single day. Due to the compounding of daily returns, the UVXY's returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors are advised to monitor their holdings consistently, even as frequently as daily.

How to profit from the UVXY:

1. Selling The UVXY Short Over The Long Term

One can profit from the VIX by shorting it over the long term. It loses value because of its leverage, which is illustrated through the tables below.

Assuming that both the VIX and the UVXY close at 15 points on Day 0:

DayVIX MovementVIX Value ($)UVXY MovementUVXY Value ($)
0-15.00-15.00
1(20%)12.00(40%)9.00
225%15.0050%13.50

As seen in the table above, after the VIX had fell to 12 on day 1 and climbed to 15 on day 2, which is its original price on day 0, UVXY's price was actually 1.5 points lower as compared to day 0. Although the numbers used in the above example are really extreme, this is what happens over the long term.

Assuming, again, that both the VIX and the UVXY close at 15 points on Day 0:

DayVIX MovementVIX Value ($)UVXY MovementUVXY Value ($)
0-15.00-15.00
125%18.7550%22.50
2(20%)15.00(40%)13.50

The situation is no different when the VIX advances then declines to the same amount as it first started, as shown in the table above. After the VIX had jumped to 18.75 on day 1, then dropped back to 15 on day 2- its original price on day 0, UVXY's price was again 1.5 points lower as compared to day 0.

This is further proven by the chart shown below, a comparison between the VIX (index) and the UVXY.

(click to enlarge)

Courtesy of stockcharts.com

Therefore, it is proven that one will benefit by shorting it over the long term. What's more, the amount it loses is pretty impressive, as shown by its weekly chart below. It had done two reverse splits in the past year, the first was a 1:6 reverse split done in March 2012; the second a 1:10 reverse split done more recently, in September 2012. The UVXY had fallen 96% year-to-date and 97.69% over the past year. Imagine the profits one would have received if he had shorted the UVXY a year ago.

(click to enlarge)

Courtesy of finviz.com

2. Buying UVXY At Times

Buying the UVXY at times instead of shorting it all the time can also be profitable, as illustrated in the weekly chart, showing the UVXY's peaks and troughs below. In February 2012, the UVXY shot from a low of $317.40 to $471.00 in a week; in May 2012, the UVXY shot up from a low of $122.50 to $248.70, doubling in three weeks; in July 2012, it shot up from a low of $65.30 to $94.40 in a week.

(click to enlarge)

Courtesy of stockcharts.com

Therefore, this chart shows that buying the UVXY at times can create a handsome profit from the trader. But the problem now is, when do we buy it? We shall explore deeper as we zoom into the daily chart, shown below.

(click to enlarge)

Courtesy of stockcharts.com

Studying the lowest points the UVXY reached before it made its most pronounced price increases, one would find that it is near the bottom of a bollinger band, or even at the exact bottom of the bollinger bands that it starts breaking out. But, it can also be observed that the UVXY tends to continue to drop when the bollinger band is dropping. Therefore, it is time to buy only near the bottom of a stabilizing bollinger band.

It can also be observed that it is time to sell (also applicable to selling short) when it hits the 20-day SMA (Simple Moving Average). As seen in the above chart, it had repeatedly tested the 20-day SMA, and that is where it starts reversing. Therefore, by these simple rules, one can create a system to trade the UVXY.

Clarifications

The first and second methods to profit are contradictory, and one is expected to either only trade using method 1, only trade using method 2, or trade using both methods, which would involve buying UVXY to cover the short position first (cover method 1), then buying more shares (using method 2). One is not expected to perform the first and second methods at the same time, which translates into not doing any trade at all.

Other (Potential) Methods To Profit

1. Selling Calls

This can potentially be a good way to profit from the UVXY, and this way of benefiting from the UVXY's contango is all the more pronounced as the UVXY options (even as far out as Jan 2014) have IVs (Implied Volatility) of up to 150%, which means that one receives more premium through selling this option.

But, there are a few key risks to this method that makes me avoid it. Firstly, it is very thinly traded. The $30 Mar 2013 call has an open interest of merely 255, and this number is already the most among other Mar 2013 calls! Secondly, the UVXY fluctuates wildly, as proven above, and this could affect the options. The UVXY could rocket on expiration date and that could bring many options in the money, making situations very undesirable for the option seller. The option seller, in the above situation, would be obliged to sell 100 UVXY shares at a lower price than it is selling in the market, which could potentially be a loss (although there would be a cushion after receiving the premiums). Thus, I would not use this method to bet against the UVXY

2. Buying Puts

This can potentially be a good way to profit from the contango as well, with its open interest at an acceptable number even for options as far out as Mar 2013. But, its IV (Implied Volatility), similar to the calls, are extremely high, reaching 150% in some cases. Therefore, one would need to pay a large premium to hold the option, which is something I do not like doing.

Secondly, the UVXY fluctuates wildly, as proven above, and this could affect the options. The UVXY could rocket near expiration date and that could bring many options out of the money, making situations very undesirable for the put buyer. The buyer could see a total loss in value of the options. Thus I would also not use such a method to bet against the UVXY.

The Takeaway

There are many ways for one to profit from the UVXY, but the options strategies are just not suitable for use because of a number of reasons, from the volatility of the UVXY to low open interest. In my opinion, I prefer selling the UVXY short better as compared to buying it at times as one can be assured that the UVXY would drop in the long term. Even so, please still do your due diligence before investing and invest only what you can afford to lose.

Source: UVXY: How One Can Profit From This VIX ETF