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How to Trade Volatility in any Environment (XIV/TVIX)

 

Volatility, or vol, is often said to have mean-reverting properties. In other words, when volatility is extremely high or extremely low, it tends to move back to the long-term mean level. With vol nears historic lows, some might think it’s time to buy volatility, thinking it could revert back to the mean. However, you can look at that both ways. If the S&P 500 continues higher, vol would remain low and the short trade could still be profitable.

Ready to learn how to trade volatility? In this post, we’ll be looking at how the CBOE VIX works, strategies for trading in volatility (whether implied or actual), and how exchange-traded products (like UVXY) with exposure to the VIX allow traders to play both sides in the short term.

What Does It Mean to Trade on Volatility?

Trading on volatility means you’re trading the volatility of the price of a stock or security rather than trading on the price of the asset itself. This means that you could trade the values of different equity indices. However, trading the volatility of these indices means you’re trading the future expected volatility of an index.

Any stock or asset whose price fluctuates experiences volatility, which means you’re simply purchasing and selling the future expectations of the stock’s volatility. So rather than predicting the actual price movements of a stock, when you trade volatility, your main concern will be how many price movements, whether up or down, will occur.

How Does Trading on Volatility Work?

The most common method volatility traders use is stock options. Options values can be affected by several different factors, but essentially, these values are the expected volatility of the underlying asset into the future. Additionally, options that you buy and sell on an equity index with higher expected volatility tend to be more valuable than options on an equity index that have less expected volatility. Ultimately, options trading is one of the best ways to get exposure to the volatility index.

Volatility Price: Implied Volatility vs. Actual Volatility

Volatility encompasses the inherent risks of trading in the stock market. Volatility gives the perception of risks that are securitized within the time-value of an option’s price. There are two main types of volatility pricing that an index strikes. For instance, the CBOE VIX measures implied volatility and actual volatility. Implied volatility means you’re working with options that encompass the expected future volatility, which is reflected in the options market. Actual volatility refers to the variable prices of the underlying market.

The VelocityShares Daily Inverse VIX Short-Term ETN provides short exposure to the CBOE Short-Term VIX.

On the other hand, the VelocityShares Daily 2X VIX Short-Term ETN provides leveraged exposure to the VIX.

What Is the CBOE Volatility Index?

The CBOE Volatility Index (VIX) is a tool that measures the expectations of the volatility of the stock market. This measurement gets reflected in S&P 500 options prices, and it’s the complex mean of various put and call options prices, strike prices, and expiration dates. Call options allow holders the right to buy underlying assets at specific prices, usually the strike price, on or prior to specific dates. These dates are the assets’ expirations dates. Put and call options can both increase in value, especially when the market’s expected volatility of the underlying assets increases.

Measuring Volatility

You can measure the volatility of any underlying security with the Volatility Index (VIX) of the Chicago Board Options Exchange (CBOE). Traders use the VIX to calculate the implied volatility of different options within the S&P 500 index over the course of a year. High readings of the VIX mean higher volatility, while lower readings mean less implied volatility over that one-year time period. So when the VIX rises, the S&P typically drops.

Volatility Trading Strategies

As you start trading volatility, you’ll find that certain strategies can help you get the most from your trades. Here, we’ll cover several strategies for options trading and trading volatility so you can understand when holding volatility trades is to your advantage and when it’s not. Generally, the most ideal strategy for trading volatility is to maximize your exposure to both implied and actual volatility. Here are several more to help you get started trading volatility:

  • One strategy for trading volatility is to short trade the asset/stock, commonly called “shorting”. In this case, you wouldn’t hold on to the volatility trade for very long. Instead, you would want to trade the volatility product as quickly as possible so you can capitalize on the fluctuations in price.
  • Establish a gamma positive or negative volatility position. In other words, you’re trading implied volatility against actual volatility. A gamma positive position would mean collecting on your trades, while a gamma negative simply means ensuring your hedging strategies result in your collections outweighing any loss.
  • Consider trading with leveraged and inverse ETNs, as they are specifically designed to provide you with exposure to their underlying indices and to amplify the underlying assets’ performance.

You may have read what leveraged ETFs are and how they could be highly risky, and we need to constantly emphasize this. Although leveraged and inverse ETNs are risky over the long term, you can confidently consider them in the short term because this is how they were designed. Inverse ETNs and ETFs provide exposure corresponding to -1X their underlying indices, while leveraged ETNs/ETFs amplify the underlying asset’s performance over one day, typically.

Keep in mind that to trade volatility is risky, especially if you’re shorting. Going long means you’re willing to lose a substantial amount of your investment in the event volatility spikes significantly.

Volatility You Can Trade On

The most volatile markets can often experience higher-than-average daily price movements. Conversely, other volatility markets may only move several points in any given day. These markets and products on the VIX are generally a good place to start when you get into volatility trading:

  • The S&P 500 VIX short-term futures ETNs or VXX
  • The S&P 500 VIX mid-term futures ETNs or VXZ
  • VIX short-term futures ETFs or VIXY
  • VIX mid-term futures ETFs or VIXM

There are many underlying assets, stocks, or securities that can fall into one of these volatility markets. Depending on your trading approaches, there are several you don’t want to hold on to for longer than necessary.

Don’t Hold These Volatility Instruments for Extended Periods

R emember, volatility trading can only provide investment results corresponding to the CBOE ST VIX’s daily performance. If you hold UVXY or VXX futures for an extended period of time, the returns will likely differ from your expectations. For example, if the CBOE ST VIX is up 10% in 5 trading days, don’t expect the S&P 500 to be up 20%.

It’s important to understand that most volatility instruments like futures, ETNs, and options tend to lose their value quickly when the stock market is rising or at a calm point. This means that it doesn’t always pay to buy and hold volatility for very long. A good example of different underlying instruments to avoid holding on to include ETNs, ETFs, and long-term futures.

For instance, the S&P 500 VIX short-term futures ETN (VXXP)is one such instrument that, if you purchase on the exchange, you won’t want to hold for very long as this index tends to swing wildly, meaning the expected short or near-term volatility may be more valuable than if you hold on to it.

Another underlying instrument you don’t want to hold too long is the VXX, which follows an index that monitors the price of several short-term VIX futures. You would trade in VXX in this case by maintaining a continuous one-month exposure period to volatility, meaning you would be repeatedly trading in first-month futures so you can purchase second-month futures contracts.

The ETF UVXY is a leveraged fund that keeps track of the short-term volatility and is a commodities pool that provides exposure to the short-term VIX futures. However, UVXY doesn’t deliver the leveraged returns on the VIX index, but rather on front and second-month futures contracts. Usually, the UVXY trades large volumes, which means a very short holding period for investors. Because of the high expense ratios, it’s best not to hold UVXY for long.

When volatility remains low and trends for an extended period, UVXY benefits, and that’s how some traders banked last year.

Final Thoughts

Although the short volatility trade has been working, it could eventually come to an end. However, that doesn’t mean you can’t trade volatility. In fact, you might consider VXX in times of high volatility and UVXY in times of low volatility. As you continue learning how to trade volatility index, keep researching these two ETNs. You could play both sides and increase your trading opportunities.

Jeff Bishop is Head of Options Trading at Raging Bull.