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Anthology Of Writings Essential To Volatility Traders

Over the last year and a half I have followed several great bloggers and read some research papers that have given us great insight into trading volatility as an asset class on the long side and the short side.

With this, my first Seeking Alpha article, I am indexing and reviewing the "must read" materials on the internet that every serious volatility trader should study and understand. Particularly if you are an individual trader or a retail investor trying to profit from ETNs like VXX, TVIX, XIV, UVXY or SVXY; you need to really educate yourself before you risk a lot of money.

So, consider this blog post as the Anthology of writings essential to volatility traders.

The articles below form the basis of my VIX education from volatility mentors who allowed me to double my IRA account in the last year with some long term swing trades.

Be forewarned, some of these articles are very heavy in math that I do not fully understand but you should read them with a view of getting the conclusions.

The VIX is a statistic, not an asset

Even though financial talking heads talk about buying the "VIX", it is not possible to buy it. VIX is a statistic that measures the implied volatility of a basket of SPX options contracts. When SPX options get more expensive, the VIX index goes higher. I urge any newcomer to trading the VIX to spend several hours reading as much as you can from Bill Luby's incredible VIX and More blog. These four articles are a starting point.

http://vixandmore.blogspot.com/2008/04/ten-things-everyone-should-know-about.html

http://vixandmore.blogspot.com/2010/05/rule-of-16-and-vix-of-40.html

http://vixandmore.blogspot.com/2009/04/lost-in-translation-vxx-and-vxz.html

http://vixandmore.blogspot.com/2012/01/year-in-vix-and-volatility-2011.html

VIX Futures are the underlying assets that make up the ETFs

José Raúl Vasquez explains how to calculate the VXX price based on VIX Futures.

http://investing.kuchita.com/2011/08/16/how-the-vxx-is-calculated-and-why-backwardation-amplfies-it/

Adam Warner writes that there is no significance of a VIX ETN having a certain value (such as a new 52 week low). "Price points in VIX derivatives have no value, though. They are driven almost entirely by math. There's no VIX value that correlates to any specific value in VXX, or any other VIX derivative. They have value as trading vehicles in that if you time a VIX move well, but use VXX, you will likely win in the short term. But they don't have value in terms of their absolute price."

http://www.schaeffersresearch.com/commentary/content/blogs/shocking+new+lows+in+the+ipath+sp+500+vix+short-term+futures+etn+vxx!+/outsidethebox_blog.aspx?single=true&blogid=111957

Futures and Options traders are betting where VIX will end up, but these bets are highly skewed by a future risk premium

VIX futures represent the market's expectation of where VIX will be x days in the future; however, this does not necessarily give an accurate prediction of where VIX will be in those x days if x is more than 30 days. Rather, the longer term futures always have a risk premium built in that reflects market sentiment (fear of the future). In this paper, Nossman and Wilhemson prove that this risk premium does exist, can be measured, and mutes the ability of the longer futures to predict where the VIX will end up. This paper also concludes that short term VIX futures (1-30 days) do reasonably predict where the VIX will be in that short term scenario.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1270525

Will the billion dollars bet on VIX ETNs and Futures affect the actual stock market? Vance Harwood explains how VIX futures are hedged by market makers and should have a neutral effect on the S&P500.

http://www.forexpros.com/analysis/can-volatility-etfs---vix-futures-blow-up-the-stock-market%20-119266

The effects of futures term structure: contango and backwardation

Steven Lee of the Third Eye Market Analyst Blog writes that the average daily cost from contango has been 0.25% for each day and the cost can rise to 0.45% as the futures near expiration.

http://thirdeyemarketanalyst.blogspot.com/2012/07/rule-of-thumb-analysis-on-cost-of-carry.html

Bill Luby explains why VXX is not a good short term holding and not a good long term holding.

http://vixandmore.blogspot.com/2009/10/why-vxx-is-not-good-short-term-or-long.html

José Raúl Vasquez writes that VXX would have lost most of its value had it existed in 2004. Even the 2008 financial crisis would not have brought VXX back to the original level. Note the excellent chart depicting this.

http://investing.kuchita.com/2011/08/21/vxx-data-since-vix-futures-avilable-march-2003/

Robert Zingale explains what happens to the VIX futures as they near expiration when they are trading at a premium to the VIX index. He also describes how much contango or backwardation are ideal for establishing short or long VXX trades.

http://seekingalpha.com/article/523651-contango-and-backwardation-s-relationship-to-vix-futures-convergence

Bill Luby shows us what happens to the VIX Futures term structure when contango gives way to backwardation like it did in late July 2011. Note how the near term futures did not increase as much as the VIX index did.

http://vixandmore.blogspot.com/2011/08/vix-term-structure-evolution-over-last.html

VIX ETN's are not a great portfolio hedge

In the series of research papers, Alexander and Korovilas conclude that "ETN market activity has spilled over to the VIX futures market, increasing the volatility of VIX futures so that they have now become some of the most risky of all exchange traded instruments". The large-scale hedging activities of ETN issuers since 2009 have transmitted volatility to the VIX futures and VIX options markets. They also conclude that the VIX ETNs "offer no opportunities for diversification of equity exposure, except during the onset of a major crisis. In short they should only be used for speculative trades".

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2027580

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2043061

Taking the other side, Jim Fink from Investing Daily describes how to a small portfolio allocation to VIX Calls can act as an effective portfolio hedge.

http://etfdailynews.com/2012/05/30/strategy-buying-vix-calls-as-a-portfolio-hedge-spy-tvix-vxz-vxx-vqt-tviz-xvz/

VIX ETN, Futures, and Options Trading Strategies

Using a simple ratio of VIX to VXV gives a measure of the term structure of SPX options premiums. It has been an excellent indicator to tell you when it is safe to short volatility. I love the way this indicator works like an oscillator giving you hints about the changing waves of fear and complacency being priced into the options markets. Vance Harwood writes that when the ratio is below 0.9 that's a good time to short volatility.

http://sixfigureinvesting.com/2012/09/taming-inverse-volatility-with-a-simple-ratio/

VIX futures tend to move in waves or trends. Up days tend to follow up days and down days tend to follow down days. Nat Stewart of NAS Trading backtests a strategy that looks at this trend effect. He also factors in the VIX futures term structure and a simple SPX trend following method to trigger a long or short volatility position.

http://seekingalpha.com/article/877011-trading-vix-futures-and-the-vxx-forward-curve-momentum-and-inter-market-effects

Robert Zingale noticed that VIX futures tend to reverse direction intraday when there is a big initial move in the morning. It would be a profitable trading strategy to short VXX after it had opened up significantly or buy VXX after it had opened down significantly. I don't daytrade but this is a great nugget that can help you time your entries and exits even if you are making longer term trades.

http://seekingalpha.com/article/585271-predicting-vxx-intraday-price-movements

Alexander and Korovilas propose a construction of simple ETN portfolios they name CVIX and CVZ that are made up of XVIX and XVZ. CVZ has a dynamic allocation that swaps the two ETNs depending on contango or backwardation. These strategies offer uncorrelated portfolio diversification and would prove to be a great buy-and-hold method of using volatility.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2062854

Michael Stokes of the MarketSci Blog gives a critique of a strategy using only RSI(2), to time VXX trades. It's a good reminder that any strategies need to be backtested back to before the financial crisis before trusting that it is a solid one.

http://marketsci.wordpress.com/2012/08/02/a-critique-of-tradingmarkets-coms-vxxxiv-strategy/

Dr. Tom Hogshead of Volatility Research has developed some indicators that will predict the movement of VXX in the short term. One is to trend Runs - the number of days in a row that VXX is up or down. By studying the run trend and watching for the trend change, they predict when VXX will reverse direction. I find this method difficult to understand on the blog but I am trying to calculate it and backtest it myself. While I don't get the same data as they do, I find this method has promise and is a good one to measure the momentum of the VIX short term futures. I am still trying to determine if it's got any predictive abilities.

https://www.sites.google.com/site/volatilityresearch/top-10-most-important-content-pages-to-read-predicting-vxx-vix-volatility-price-trends-and-google-search-rankings

In this academic paper, David Simon concludes that "the VIX futures basis does not accurately reflect the mean-reverting properties of the VIX spot index but rather reflects a risk premium that can be harvested." Simon studies a strategy of selling or buying futures based on contango/backwardation and then hedging the position with mini-S&P futures contracts to offset the chance that there is a significant move in the level of the futures.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2094510

Steven Lee of the Third Eye Market Analyst blog gives us a process to forecast VIX and VXX based on whether the VIX is lower or higher than other volatility measurement models such as GARCH and Implied Volatility of S&P 500 index options; and by looking at the historical probability of VIX levels relative to the current S&P 500 trend.

http://thirdeyemarketanalyst.blogspot.com/2012/08/essential-guide-to-understanding.html

Robert Zingale gives an interesting strategy of investing in a dynamic allocation of long VXX, short VXX, or Treasuries depending on the level of contango in the first to second month VIX futures.

http://seekingalpha.com/article/305062-new-strategic-volatility-etf-concept-shows-more-promise-than-volatility-etf?

In the two following articles, Michael Stokes of the MarketSci Blog describes how to use the contango/backwardation and a 10-day EMA of the VIX index as part of strategy to time VXX or XIV trades.

http://marketsci.wordpress.com/2012/04/11/strategy-1-for-trading-volatility-etps-term-structure-following/

http://marketsci.wordpress.com/2012/04/12/strategy-2-for-trading-volatility-etps-timing-the-vix/

It is clearly a winning bet to short volatility after a large spike in volatility (if you get the timing right). Bill Luby of the VIX and More blog discusses options strategies for shorting volatility after a major Volatility spike. Using options you can limit your potential losses and still have a possibility for large gains.

http://vixandmore.blogspot.com/2012/04/buying-svxy-calls-when-vix-spikes.html

Kevin O'Brien uses a reverse iron condor options spread strategy on VXX weekly options contracts for weekly profits. Since VXX is a volatile product, the options strategy profits if the ETN moves higher or lower in a few days.

http://seekingalpha.com/article/395931-using-a-weekly-options-strategy-on-the-ipath-s-p-short-term-futures-vxx

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I hope you enjoyed my collection of favorites. I have some Google alerts in place to find when something new has been posted. I continue to add to my favorites as new compelling articles are published.

Please leave comments if you have any recommendations of articles that should be included in this collection of essentials. Which articles were your favorites?

My current interest is in developing indicators and strategies to time VXX and XIV swing trades in my IRA account with a high degree of confidence. Comment or message me if you have suggestions for good indicators you use to time your trades.

Disclosure: I am long XIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.