On Monday, volatility, as measured by the Volatility Index (VIX), increased by more than 20% in one day.
While your broker was likely running for cover and your hands were frozen on the keyboard, you could have been sitting back and enjoying the show… if you were holding a position in volatility, that is.
I learned how to trade volatility the hard way. But I love when the market teaches me a lesson… It sets me up for years of profits going forward.
Now I’m sharing what I learned, so you won’t have to make the same expensive mistake I did.
What Is the VIX?
The VIX – which I have written about several times – measures the market’s volatility based on the number of put or call options being bought on S&P 500 stocks.
When people buy call options, they are betting the market will head higher and the VIX will move lower. Vice versa, when they buy put options, they are betting the market will go lower and the VIX will move higher.
The VIX is a reactionary indicator. It moves after the market has already started moving – in one direction or the other. But that doesn’t mean you can’t make a bet that will pay off. All you need is a volatile market… and that’s what we have today.
How to Trade Volatility
I trade volatility using the iPath S&P 500 Short-Term Futures ETN (NYSE: VXX), also called the VXX. Sometimes I trade the actual exchange-traded note (ETN), but most often I trade the options on the ETN.
The VXX is a short-term instrument, just as its name suggests. That means the notes are priced for daily movement and will lose value over time if the VIX doesn’t make a sharp move either up or down.
Logic would suggest that if you think volatility is going to increase over time, you should buy longer-dated options on the VXX.
After all, having time on your side when it comes to options trading is usually best, as it allows for events to unfold that may send your underlying investment lower or higher. If you bet on the right direction, you can win big.
But with volatility investments like the VXX, it doesn’t work that way.
Since futures – like options – rely on time value, the pricing of the VXX is subject to leakage. That’s the fancy term for the loss of value of the VIX contracts as time expires.
Furthermore, the VIX does not make sharp moves higher or lower for periods of more than a few days or weeks at a time. This means that longer-term options lag in performance over shorter-term options, as the market knows the VIX will eventually settle down.
The way to make a bet on the VIX is to buy either short-term put or call options with strike prices about 10% from the current levels. These options should expire within a few weeks at most.
Take the move this past Monday, for example, when the VIX jumped up. In turn, the VXX moved 18% from around $32 to $38. I purchased July $38 options about a week ago when the VXX was at $34. My options gained more than 300% by the close on Monday. I closed out half the position and am riding the rest for a few more days.
To sum it up, volatility trades should always be short term in nature. Paying more money for a longer-term position has never paid off for me.
Volatility is a short-lived event… Invest accordingly.