The VIX Explained

The VIX is a well debated, but much misunderstood index. You’ll often hear financial media pundits refer to it as the “fear gauge” or “fear index” of the stock market, which is mostly true. Put simply as possible, the VIX projects the implied volatility of the S&P 500 for the next 30 days using S&P 500 options.

The VIX is mostly used as an indicator of market health, similar to the S&P 500 or Dow Jones Industrial Average. While it has application in this realm, most traders and investors are unaware of the trading opportunities presented by the VIX and its many derivatives.

Rather than using the VIX as a mere indicator, many traders opt to trade derivatives of the VIX itself. Most VIX trading strategies are based in the philosophy of mean reversion, rather than trend following. After all, the VIX mostly moves sideways, trying to trade it like a trend follower would prove difficult.

 

Strategy One: VIX Market Timing

This is the most basic of VIX strategies, to put it simply: wait for a spike in the VIX, and go short your favorite VIX derivative. The theory here is that after VIX spikes, it slowly trends back to its baseline.

In this example, we will use the SVXY ETF, which tracks VIX Short-Term Futures, as our trading vehicle, as virtually any trader can access it, in contrast to an actual futures contract. To learn more about how SVXY works, check out Six Figures Investing’s excellent article, “How Does SVXY Work?”

We will use the VIX index itself to generate trading signals. We only need one indicator, Bollinger Bands, plotting 2 standard deviations on either side of a 20-period moving average.

VIX Bollinger Bands

  1. Wait for the VIX to make a two standard deviation move on the upside, on a daily chart.
  2. Once it has spiked, move down to a 15 minute chart.
  3. Wait for the slope of the moving average on the 15 minute chart to move downward, this prevents you from getting short a spike too early. (see chart 2.A)
  4. Close your position once the VIX has reverted back to it’s 20-day moving average on the daily chart.
  5. Stop loss (optional): Two times the Average True Range of the daily chart. I use a smoothed ATR, it consists of a 20 period EMA of the 14 period ATR. This is the same indicator used by Richard Dennis and the Turtle Traders for their risk management.Vix Trade EntryChart 2.A

Winning Trade Example

Here’s what a winning trade looked like in the VIX, the index we’re using to generate trading signals:

VIX Winning Trade 1

And here’s what that same winning trade looked like in SVXY, the security actually traded.

SVXY Winning Trade 1

Losing Trade Example

Here’s what a losing trade looked like in the VIX, the index we’re generating trade signals from:

VIX Losing Trade 1

And here’s what a losing trade in SVXY looked like, the security being traded:

SVXY Losing Trade 1

Strategy Two: Day Trading the VIX

This strategy takes advantage of two factors that push leveraged volatility funds down over time: contango and the folly of leveraged ETPs. The two links attached explain the factors in detail. However, for this strategy, all you need to know is that, unless there is a catalyst, these leveraged volatility ETPs almost always go down. They come with huge risks, but of course huge risks would come with a security that goes go down so consistently over time.

The ETPs that we can trade with this strategy are as follows:

  • UVXY
  • TVIX

There are more, but these are the liquid ETPs that track VIX Short-Term Futures.

The setup of the strategy is very similar to the previous strategy. Only one indicator is required, which is Bollinger Bands. In this example we will use the UVXY ETF. To learn more about how it works, refer to Six Figures Investing’s excellent article, How Does UVXY Work?

Time frame is variable. The longer the intraday time frame, the less noise, but you also don’t want to be in one of these trades too long. I like to stick with 15 minute charts, personally. This is generally what your chart should look like:

UVXY Bollinger BandsUVXY, 15 minute chart, Bollinger Bands (2, 20)

 

This strategy does not generate trade signals from the VIX

Here are the parameters of the setup:

  1. Wait for UVXY to make a 2 standard deviation move upwards on your intraday time frame of choice.
  2. Enter UVXY on the short side
  3. Close the trade when it has reverted back to it’s 20-period moving average.
  4. Stop loss (optional): Two times the Average True Range of your time frame. I prefer a smoothed ATR, I use a 20 period EMA of the 14 period ATR, this is the same indicator used by Richard Dennis and the Turtle Traders for their risk management.

Here’s an example of some trading opportunities to take this trade presented:

UVXY Trading Oppurtunities

Winning Trade Example

Here’s an example of what a winning trade looked like:

UVXY Winning Trade

Losing Trade Example

Here’s an example of what a losing trade looked like:

UVXY Losing Trade

Huge Risk

Trading volatility is an extremely risky act and is only for the most risk tolerant traders. These trades are very high probability and the gains are great when they’re coming, but sometimes, the losses are intolerable. When trading the VIX, a bad trade could mean the end of your account, and you may owe your broker money.

We recently saw SVXY’s brother ETP, XIV get terminated by Credit Suisse after a more than 80% drop in its price. The price of SVXY recently dropped from over $100 to $12 in a matter of days.

If shear numbers aren’t enough to scare you into viligant risk management when trading volatility, take the words of a Redditor from /r/tradeXIV after the collapse of XIV:

I’ve lost $4 million, 3 years worth of work, and other people’s money”

 

Summary

Like any trading strategy, trading volatility will have its drawdown periods and its excellent periods, however, trading volatility is especially risky, so please heed the warnings earlier in this article.

Volatility trading has been on the forefront of the news in the last year or so, its been a cliche that banks and institutions were “permanently short” the VIX until the retail traders began to catch wind of the trade. Recently, a former Target manager became a millionaire shorting volatility.

Here’s a few resources to learn more about volatility trading: