3 Ways To Trade Volatility

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Includes: JNK, VCLT, XIV
by: Tautvydas Marciulaitis

Summary

Everyone is talking about low volatility and how it won't last.

But to gain from that, one must be prepared and have a viable strategy.

There will be number of opportunities for different investors, ranging from bond ETFs to futures.

Try to find out the best one for you - as it is not enough to know that markets will crash, it is important to know what you will do about it.

Low volatility

Everyone knows that for quite some time now we've been living in low volatility environment and that it is unprecedented (please read this great peace about it here on SA). VIX is at levels seen only during the years before the Great Recession of 2008. Thus more or less everyone agrees that such situation should not last and in foreseeable future VIX will go up and markets will crash. So how do we play this out ?

Chart ^VIX data by YCharts

Preparation

In order to gain from market crash, you need to have excess liquidity. Put simply, enough cash in your account to start buying, when market tumbles.

It may look rather obvious, but it is very easy to become too greedy during market boom. As behavioral economists proven many times, people tend to become greedy when they are lucky (hot-hand fallacy). Due to what many investors (especially rookies) refuse to wind down positions, while everything is going up, leaving them both exposed and unprepared for and after the crash.

Don't be one of them. Start reducing risky positions and try to hold at least 20-50 percent of your portfolio in cash. Currently risk-return, especially in equities, is heavily skewed towards risk due to the over-optimism, meaning very low implied Sharpe ratio.

What to buy if you are cautious ?

As markets are heavily interconnected, crashes are often not contained within equity markets. Usually investors sell higher risk bonds also - starting with non-investment grade (junk) ones and sometimes extending the sell-off to longer-term corporate bonds. Especially if risks are systematic.

As seen below, the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) (the graph above), which invests in non-investment rating U.S. bonds, tends to react rather dramatically to market sell-offs. During 2007-2009 it lost approximately 40 percent of its value. It also crashed during the second half of 2015 and the beginning of 2016 - when equities were going down due to situation in China.

Chart JNK data by YCharts

While the Vanguard Long-Term Corporate Bond Index ETF (NASDAQ:VCLT) (the graph below), which invests in long-term corporate bonds, is rather more sensitive to monetary policy announcements than developments in equity markets, it is still volatile and may lose as much as 10-15 percent in short periods of time. Thus it is very tradeable.

Even though it is not guaranteed that VCLT will react to turmoil in equity markets, JNK most definitely will. Thus cautious investor may use one of these (or similar) instruments to take advantage of increase in VIX.

The best part is that as along as default rates do not skyrocket (you can follow leading indicator for default rates here at FRED), bond ETFs regain their value over time, giving investor both capital and good dividend gains (more on bond ETF trading).

Thus cautious investor may expect to earn 4-6 percent in yearly dividends and 5-15 percent in additional capital gains, when investing in bond ETFs after equity markets crash.

Sounds boring ? Okay - a bit more riskier strategy

Another great option, especially if you are a risk loving trader, is to buy a broad equity index, such as Russell 3000 or S&P 500. Buying a broad index usually does not lead to a jackpot, nevertheless returns can be substantial.

It is easy to understand why it is rational to buy equity indices during crashes - as they crash, you can simply buy them cheaper. The key in being successful when doing this is being smart enough not to use leverage and having enough liquidity to execute the whole buying via number of different orders, rather than a single BUY @ MKT.

If you are leveraged, then buying indices or equities when markets are crashing, is purely stupid. In 2007-2009 equity indices lost 50-70 percent (peak-to-valley) of their value, meaning that even 1:2 leverage could have destroyed a leveraged buyer. Thus no leverage should be involved here.

Chart SPY data by YCharts

In addition, no one ever knows when and where market will bottom-out. Thus the most rational strategy is to execute the whole buying trade via number of orders - for example to buy every time market drops by 5 percent.

It is also necessary to have enough patience to start buying only after the fundamental events (or at least rumors) confirm that there is something wrong. As buying too early means that either you are buying market noise, or buying into large movement too early.

This is the hard part. There is no easy way to determine when exactly it is rational to start buying or how exactly to execute this trade. Many investors either start buying too early, or use leverage. Due to what, their strategies fail and they end up bankrupt.

Do not fear to loose potential profit due to not starting the buying early enough. It is better to forego theoretical profit, than actual money. Thus it's better to get into too late, than too early, as it will cost much less.

The only way to do this properly, without too much luck, is to have deep enough pockets and great deal of discipline. And apart from these tiny details, buying equity indices, when they are crashing, is rather straightforward. Simply buy, when markets offer a cheaper price and enjoy the return, when everything normalizes. Remember, if markets drop by 10 percent and you buy them, by the time they come back to their highs, your position gains 20 pct.

For the big boys

For those who need more adrenaline and want to hit the jackpot, VIX futures (long-short strategy) and the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) are the two best options. Lets start with XIV.

XIV is an inverse VIX ETF. Without going into the depths of mathematical properties of these two instruments, when VIX goes up, XIV goes down and vice versa.

As we know, in essence VIX is an index of implied volatility derived from options prices, which is bound to stay between 0 and 100. That means a lot of things, but in this context, the most important is that, put very simply, if markets expects 10 percent volatility, VIX stands at 10. While if something happens and market starts to expect volatility to rise to 30, VIX (in theory) should jump to 30 - a 200 percent increase.

This means that VIX is very volatile, what obviously means that XIV is very volatile. And here starts the fun part:

Chart ^VIX data by YCharts

When VIX jumped to 35ish in 2015, XIV crashed by 50 percent in approximately two weeks. However, as VIX entered its current state by the end of 2016, price of XIV almost doubled in just 6-7 months.

The key here is that as long as there is no obvious systemic risks, meaning that premiums on longer term options do not increase by much, XIV remains quite stable. Nevertheless the moment markets start to expect problems in mid/long term, XIV can crash by 50 percent or more in days.

However, the best part about XIV is that it is mathematically bound to increase in value as long as VelocityShares do not go belly-up. As it sells VIX futures, term structure of which are usually in contango, sales of front month futures have negative time value (positive if you are a seller), implying that every month XIV gains value just due to the contango.

VIX Term Structure (Source: VIX Central) To put it simply, if you sell august futures today, by the end of July, ceteris paribus, you can expect to gain 12.53-11.750=0.78 on a single contract (780 US dollars on a standardized trade). And as long as the longer term contracts are more expensive, you can repeat this procedure.

As over the long term this is usually the case, XIV actually keeps on doing it and that is why this ETF is mathematically bound to always increase in value. But there is a catch.

If markets go down and VIX jumps, for every point on every contract you hold, you need additional 1000 USD for collateral. Meaning that if VIX jumps to 50, you need 50k as a collateral for every contract. Unless CBOE asks for more in distressed times, then you would need more. And if unfortunately the contract expires at 50, you pay up the 50k. Thus one needs really deep pockets to conduct this trade.

However, there is a workaround. It is not present at all times, but sometimes one can quasi-arbitrage the VIX term structure. Remember when I told you that during normal times, VIX futures term structure is in contango ? Well, that is true until times are not normal.

VIX Contango (Source: VIX Central) Sometimes VIX futures term structure enters backwardation - meaning that longer term futures are less expensive than short term futures. During such times, it is rational to short-sell the near term futures, while buying longer term ones (long-short position on term structure).

By doing this, you get few things:

  1. A semi hedge - if VIX continues to go up, the whole curve usually shifts up, so losses are somewhat less if compare to naked short (loss on short, gain on long position);
  2. A mathematically plausible trade - short term futures are more volatile and VIX usually is in contango, meaning that when everything normalizes, front-end futures will depreciate much faster than longer ones, which will allow to profit from short position, while long position will generate far less loss.

Of course such trade requires much knowledge, experience and capital. Nevertheless, it is one of the best trades one can make with VIX futures. However, if You are not into that - there are number of options described above, please feel free to use any of them.

Are You ready?

It is one thing to know that current situation is not normal. However it is much different to know how to use it to your advantage. I hope that this will be helpful in deciding which strategy to use and what to do, when time comes and VIX moves towards 30-50.

Market crashes and crises are the best times to make money. You just need to be prepared for them. Those who fail to prepare, lose. Those who prepare well, pray on other's losses. That's how it always works, you simply have to choose your side.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.