As Russia launches strikes against Ukraine, the price of gold futures has spiked from a close of $1910.4 yesterday to over $1970 as I write this. I wrote about a possible flight to safety a couple of days ago, and you can read about that in detail here. Gold is still one of my favorite long-term trade ideas, and this breakout could be just the beginning.
In these volatile times, it is important to understand how to hedge your portfolio and be able to trade this volatility.
The VIX is the Fear Index. Typically fear increases as market indexes fall. It is possible to trade the VIX and thus fear synthetically through products such as VXX and UVXY.
VIX Explained
The VIX is the Chicago Board of Exchange (CBOE) Volatility Index. It is derived from the prices of SPX index options with near-term expiration dates. It generates a 30-day projection of volatility i.e. how fast price changes. It is essential because it is used to gauge market sentiment, particularly the degree of fear among market participants.
Typically fear increases as market indexes fall. Thus the VIX will usually rise as market participants look to hedge their positions in falling stocks by buying put options that will offset their trades.
The greater the fear, and rate of change in the decline of prices, the greater the price of the VIX.
Above is a four-year daily chart of the VIX. As we can see, rarely does the VIX break above 30 and hold for a sustained period in a bull market. However., when this occurs, it coincides with significant declines, as seen below in a chart of the SPY in 2020 when VIX spiked to over 80 and held over 30 for multiple weeks.
SPY crash of 2020 when VIX spiked to 80 and held above 30 for multiple weeks
In fact, some institutions and institutional investors go so far as to say that a VIX over 30 is “uninvestable.” These large players may avoid making investments on the long side while the VIX is over 30.
The main reason for this is that when the VIX is low, i.e. < 20, stocks grind higher, and investors feel safe to put funds to work. Usually, the market grinds higher slowly outside of unexpected extraneous events.
As traders, we can use numerous products either as indicators to help make decisions or to trade volatility itself. One such instrument is the UVXY.
UVXY- A Synthetic Derivative
The UVXY is the PROSHARES ULTRA VIX SHORT TERM FUTURES ETF (UVXY).
The UVXY is a continuous 30 day synthetic of VIX futures, an enormous fund run by ProFunds Group. It represents a portfolio comprised of the two front-month VIX futures contracts. UVXY is slightly different than VXX because it is usually between 1.5 to 2x leveraged. This means that UVXY will return between 1.5 to twice the percentage of VXX on a given day.
Trading UVXY
When markets get shaky and become gripped by fear, traders can hedge their portfolios by buying UVXY. If stocks go lower, UVXY should go higher and thus offset some losses. This is a way of buying insurance against a Black Swan market event.
For example, today, the Russian Stock market was down over 30% in 1 day. Some blue-chip Russian companies were down as much as 50% from the overnight close, such as Sberbank, a leading Russian bank. Whilst such a Black Swan event in the U.S markets is unlikely, it is nonetheless very possible.
History repeats, and there is always the possibility that a 1987 style Black Monday event will occur sooner or later in the U.S. On that day, the Dow Jones Industrial Average dropped 22.6 percent. Some insurance against this type of event can go a long way!
Personally, I think the U.S markets are oversold and are due for a bounce. What do Russia and Ukraine have to do with stocks like Facebook (FB) and Paypal (PYPL)? Not much for the time being. But the UVXY provides traders with insurance against unlikely events.
Bottom Line
VIX is a measure of volatility. We can trade it through synthetic contracts such as UVXY. These products have their structure governed by a charter set up by its fund. Volatility usually increases when markets go down as fear increases and participants want to hedge their positions. As a trader, I want to trade these products to find opportunities when markets become more volatile.
I can buy UVXY as insurance against severe corrections in the stock market. Or if I think that markets will bounce, I can sell UVXY short as it usually trades inversely to the SPY.
In these volatile times, UVXY is an Indicator I have up and am watching closely when making trading decisions.
