Using The VIX To Trade In Volatile Times

Current volatility offers opportunity in trading VIX

The Chicago Board Options Exchange Volatility Index (VIX), is a term used to describe the implied volatility of the market price of S&P 500 options, 30 days into the future. The term “implied volatility” means that the measure of volatility is based on the market price rather than the initial price.

The VIX indicates the expected movement of the S&P 500 (SPY) over the next 30 days, expressed on an annualized basis in percentage points. For example, at the closing bell on October 10, the VIX was at 16.48. This means that the market expects that the S&P 500 will move in either direction at the annualized rate of 16.48 percent over the next 30 days. Keep in mind that this is not calculated as 16.48 divided by 12, but rather as 16.48 divided by the square root of 12, which equals 4.75. This means that the index option market expects that the S&P 500 will move 4.75 percent in either direction over the next 30-day period.

Many investors assume that the VIX is limited to downside volatility and that it is always a bearish signal. This is wrong. Consider that a stockholder willing to write an option against a 100-lot of stocks which he expects to increase greatly in value will want to charge a higher price than what would be charged for a stock which is expected to make a meager advance. The purchaser of that option will be paying a higher price for the option and taking a greater risk. The volatility for that stock will be greater because the value of the stock is expected to make a more significant swing. In other words, an increasing VIX is not necessarily a bearish signal, although most investors see it that way. This is why the VIX is often referred to as the “fear index” by those who assume that the significant swing anticipated by options traders is expected to be toward the downside.

On Thursday, the S&P 500 (SPY) made a move to the upside in excess of over two percent (2.18) and the VIX sank. Most investors assumed that the VIX sank simply because the S&P rose. Actually the VIX declined from Wednesday’s 19.60 because S&P 500 options traders expect the S&P 500 to move 4.75 percent in either direction over the next 30-day period, rather than 5.65 percent in either direction over the next 30-day period, as was assumed on Wednesday. In other words, the 2.18 percent surge by the S&P 500 on Thursday made a 5.65 percent move in either direction over the next 30 days less likely, although a 4.75 percent move was within the anticipated magnitude of change.

Despite the decline by the VIX on Thursday, rest assured that more of those wide swings by the S&P 500 are exactly what will send the VIX higher. After all, it is volatility we are talking about and nothing enhances volatility more than wild swings by the S&P 500. Despite what many investors and traders believe, staring at charts alone will not tell you what is causing the S&P to move. “Facts on the ground” play a key role and right now the ground is quicksand. As a result, you may want to consider taking advantage of one or more of the following exchange-traded products, which are based on the VIX:

iPath S&P 500 VIX Short-Term Futures ETN (VXX): This is an exchange-traded note, which is designed to track volatility in the markets as measured by the Chicago Board Options Exchange Market Volatility Index (CBOE Index), a popular measure of the implied volatility of S&P 500 index options. The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) prices itself off of the average and implied volatility of the first two months of futures contracts of the S&P 500 Index.

VelocityShares Daily 2X VIX Short-Term ETN (TVIX): This ETN is designed to track twice (2X) the return on volatility in the markets as measured by the S&P 500 VIX Short-Term Futures Index. As a result of the enhanced stock market liquidity fueled by quantitative easing, the share price for TVIX fell to $1.50 and it was at risk of being de-listed by the Exchange. As a result, VelocityShares did a reverse, 1-for-10 split for TVIX shares.

Nevertheless, TVIX spent most of September below $14 per share, due to reduced investor participation. For this reason, TVIX has struggled in achieving its objective of moving twice as high as VXX, when warranted. This has caused many investors to follow the alternative route of taking short positions on the Velocity Shares Daily Inverse VIX Short-Term ETN (XIV), an ETN which was designed to inversely track the volatility in the markets as measured by the S&P 500 VIX Short-Term Futures Index.

Bottom line: The current political standoff inserts significant volatility into U.S. and global financial markets. VIX and VIX ETNs offer an opportunity to trade current conditions.

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