Doing The Unthinkable: Going Long Volatility

| About: iPath S&P (VXX)
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Summary

After successfully trading volatility from the short side, I'm considering going long volatility.

A confluence of factors make me think a correction is near.

A short term trade to take advantage of a spike in volatility is risky and great caution should be exercised.

A couple of weeks ago I profiled my short volatility trade that I put on as the equity markets were tanking in October. As a quick recap, I went long the volatility ETF (NYSEARCA:VXX) and inverse fund (NYSEARCA:SVXY) as markets were bottoming in October and volatility had spiked. I was out of the trade in a couple of weeks with a 36% gain as volatility returned to normal and SVXY is within a couple of percent of where I sold it a couple of weeks ago. I will certainly be looking to put this trade on again but now is not the right time, as I explain in the above linked article.

But what about the other side of the trade? With volatility back near its lows, or at least what I'd consider a "normal" level, is it time to dip our toes in the forbidden waters of going long volatility? I've never been long volatility before because there really isn't a great way to do it. Even the unleveraged vehicles available to retail investors like VXX suffer from poor tracking and decay problems. But the VIX itself is impossible to invest in since it isn't an index in the sense the S&P 500 is, which is easily tracked by ETPs.

So why am I saying such crazy things? In short, I think we're probably near a topping point in the equity markets. And yes, I know trying to time the top is a fool's errand and can lose you a lot of money over time but there are enough factors that make me think volatility will spike in the near future that I'm considering a long position in volatility.

Keep in mind, a long volatility position is not an investment; it's a trade where you get in and get out when the move happens. It worked well when I was short but my timing was pretty close to perfect. That's not a function of me being a genius or something; I got lucky. I had a sense the selloff was overdone but I had no way of knowing the indices wouldn't fall another 20% or 30%; that is the danger when playing with volatility on the long or short side. The same goes for this trade; you can get run over going long volatility so if you decide to act, please be very careful.

So what caused the change in my view? For one thing, we're sitting at new all-time highs. The major indices continue to march higher on no real news. Valuations are stretched to say the least as P/E ratios have soared to 18 on the S&P 500. I'm not a CAPE guy or anything like that but when the major stock index in our country is sporting an 18 multiple, I take notice. That doesn't mean a crash is coming but I do think it means gains will likely be muted for the foreseeable future. And when gains are muted, volatility usually ensues at least for short bursts and that is the point of this strategy, to capture those bursts.

Mercenary Trader points out in this enjoyable article that the S&P set a record for consecutive days closing above its five day moving average. That is quite a feat considering how many decades have passed without it occurring before now and if you think about it, a market that has gone straight up for that long must correct at some point. Gravity will take effect at some point and volatility will pick up. And given the fact that the Fed's unprecedented QE has officially stopped expanding and the shock in the oil market in recent weeks, I think there is plenty of reason for traders to get antsy and see volatility spike.

So let's assume that you're crazy enough to follow me in; how do you do it? As I said earlier, there aren't many great ways to go long volatility because the products available suffer from decay and tracking error. However, that doesn't mean there isn't money to be made (and lost). You can simply get long the good old VXX, the ETN that is purported to track the VIX short term futures. It is certainly the most recognized and liquid of the VIX trading vehicles and offers liquid options as well if that suits you.

There are also leveraged products like UVXY (2X VIX) and TVIX (also 2X VIX) and on the short side, XIV, which is very similar to SVXY. Any of these products, used in the proper way, can get you long volatility. I still prefer the VXX to go long because the levered products will really get crushed if you're wrong and with volatility, you just never know because, well, it's volatile.

I'm seriously considering going long volatility here as I think things are just setting up too nicely for a correction. To be clear, I'm not calling for a crash or something, I just think markets are frothy and complacent and when that happens, a snapback is needed to whip everyone back into shape. I won't go near short volatility at this point and while December may turn out to be tranquil, that's not a risk I'm willing to take. I'd love to hear what you think about going long volatility here so please, share freely.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.