How To Profit From Rising Volatility

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Includes: EFA, GLD, SPY, VIXY, VWO, VXX, XIV
by: ETFguide

By Ronald Delegg

Stock market volatility is often wrongly portrayed by the mainstream media as an enemy. In reality, it's not.

First, prudent investors use volatility (ChicagoOptions:^VIX) as an effective tool to measure the stock market's psychology. Why? Because excessive bullishness or bearishness in market prices is instantaneously reflected in the VIX. And therein lies the opportunity! At ETFguide, we use VIX readings in conjunction with other leading indicators to improve our odds of making profitable investments. (It should be noted that volatility readings also exist on other asset categories including international stocks (NYSEARCA:EFA), emerging market stocks (NYSEARCA:VWO), and gold (NYSEARCA:GLD)

Aside from being a sentiment barometer, volatility is also a short term trading tool that can be used as an effective hedge against falling stock prices. But even when stock prices aren't falling, there are still profits to be had in the VIX.

The chart below illustrates the point.

As you can see, the S&P 500 ETF (NYSEARCA:SPY) has basically been flat since late October with a modest loss of -0.20%. The typical investor underperforms the market, so it's fair to assume most have suffered even worse performance compared to the S&P. Yet, did you notice how during this same time frame the VIX soared 25%? Given the S&P 500's flat performance since late October, a +25% gain in anything - let alone volatility - is really a big deal. Where was the profit opportunity?

Ahead of this +25% jump in stock market volatility or VIX, we wrote the following in ETFguide Premium on Oct. 21, 2015:

"Stock market volatility has fallen off a cliff over the past month, declining by -17% while the SPDR S&P 500 (SPY) has risen +2.74%. Meanwhile, the VIX - which measures S&P 500 volatility - now hovers in the 14-16 area. For volatility bulls, current levels offer another interesting trade setup. We're buying the ProShares Short-Term VIX Futures ETF (NYSEARCA:VIXY) at current prices near $13.55 up to a buy limit of $14. Our tandem options trade is to buy the VIX Jan 2016 $15 call options (VIX160120C00015000) near $465. The calls expire on Jan. 20, 2016 and our goal will be to sell them for a gain ahead of expiration. "

How did it work out?

We sold our VIX JAN 2016 $15 call options for a timestamped +22.5% gain on Nov. 13 and our VIXY ETF was sold on 12/11/15 for a timestamped +14% gain. (Incidentally, our other VIXY trade - a five-month trade from April-August 2015 was our best unleveraged trade of the year. It ended on 8/26/15 for a +29% timestamped gain.)

VIX call and put options are ideal if you want to closely replicate the daily movements of the VIX and if you have a specific time frame for the trade in mind. On the other hand, VIX ETPs, (NYSEARCA:VXX) which include both ETFs and ETNs, are a next best choice if you're not comfortable with trading options.

What's better VIX ETFs or VIX ETNs? We prefer to use VIX ETFs to avoid the credit risk associated with ETNs. In 2008-09, when Lehman Brothers Opta ETNs disintegrated, investors lost everything and it set an adverse precedent for how future ETN meltdowns (NASDAQ:XIV) will likely be handled.

As the ultimate mean reverting beast, the VIX offers plenty of great trading opportunities even when stocks are flat or slowly trending lower.

In the end, the best way to capitalize on future VIX moves (up or down) is summed up in just three words: Always be ready.

Disclosure: None

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