Tips for Trading VIX ETPs

Hey Trader,

The week between Christmas and New Years is always interesting …

With the week typically being low-volume, you might expect markets to stay quiet.

But I’ve noticed it isn’t uncommon to see some action – either a big swing up or a big swing down – that keeps things interesting.

Last week we saw some wild moves out of volatility … from a 27 VIX to a below-18 VIX is quite a range during a holiday-shortened week.

I am expecting to see the VIX move lower in the immediate days ahead … that being said, we could see a bounce higher if vol gets oversold, or we get some news.

Given the wild action we’ve seen lately, I think now is a good time for a little review of trading VIX … or rather, VIX exchange traded products (ETPs).

VIX ETPs can practically print money when you play them right at the right time …

But there’s some very important caveats to know before you dive in head first!

Trading VIX exchange traded products (ETPs) can be an excellent way to play VIX without actually playing VIX (or rather, VIX futures, since you can’t trade VIX directly, which you already knew, right?).

However, there is a major issue with VIX ETPs that will gobble your trading capital right up if you aren’t aware of it!

But first, let’s take a look at two of the most well-known VIX products, iPath S&P 500 VIX Short-Term Futures ETN (VXX) and ProShares Ultra VIX Short Term Futures ETF (Ticker: UVXY)!

There are, of course, other vol products out there, each with their own unique twists and quirks, so you need to know the intricacies of what you are trading before you start making moves.

VXX tracks a constant 30-day maturity VIX futures … essentially, it’s attempting to replicate a long VIX future with a constant duration of 30 days. It does this by holding the two nearest-dated VIX futures contracts, and as time passes, it sells the front-month future to buy the next month.

For example, the day after expiration, VXX will hold all front-month futures with 30 days to expiration. 

Halfway to the next VIX expiration, VXX will hold half front-month futures and half second-month futures.

The day before VIX expiration, VXX will hold almost all second-month futures (which then become front-month futures after expiration).

This is where VXX runs into trouble.

Think about what we know about VIX futures … 

The front-month VIX future must equal the VIX index by the time of expiration.

And VIX futures are typically in a contango pattern – where futures are trading progressively higher than spot VIX.

So when VXX is selling the front month and buying the second month …

They are essentially buying high and selling low … pretty much the opposite of what you typically want to see happen!

As a result, VXX is pretty much constantly hemorrhaging value … take a look at the two-year chart:

With the exception of smaller volatility strikes, you’ll notice VXX is pretty much exclusively trending lower.

This trend is even more exacerbated with UVXY, because UVXY essentially offers the same VIX future exposure that VXX does … except 1.5 times leveraged.

That means it moves at 1.5 times the rate of VXX … and decays 1.5 times as fast.

So if you are looking to trade a directional VIX move using either of these ETPs, you will want to keep this difference in mind.

Neither candidate is good as a buy-and-hold investment. 

If you are confident on your timing, and know you will be able to get in and out quickly, UVXY might offer even better profit potential.

But if you are less precise with your timing, VXX offers you a way to play directional vol without the exacerbated rate of decay.

It is especially important to note that while VXX does decay dramatically over time, when it comes to tracking volatility intraday, the ETP does work as it is supposed to … it tracks the movement of the VIX. This makes it a good option for day trading volatility (or short-term swing trading, with a hold time of a day or two at the most).

Another benefit to trading these ETPs is that because we know VIX futures are in contango approximately 80% of the time, we can count on UVXY and VXX to usually be moving lower. When you feel confident we won’t be looking at short-term vol spikes, using puts to take advantage of this decay can net you some pretty solid profits.

Of course, these days, when can we count on not seeing short-term vol spikes?!

There are a few conditions you can check for to make sure the odds are swinging in your favor.

First, obviously, you want to check the current movement of the VIX. If the VIX is moving from a higher volatility zone to a lower volatility zone, then that is a sign in favor that vol will continue to fall, and purchasing puts on one of these ETPs may be a smart move to make.

But you can’t stop there. You want to also check the current realized volatility of the S&P 500 (Ticker: SPX). If realized volatility is rising, implied volatility (and therefore the VIX) may soon follow.

Finally, you will want to look at the VIX futures curve, and make sure they are in a contango.

While it is not a requirement that all three of these conditions (falling VIX, falling realized volatility, and futures curve in a contango) be met, the more that are, the better conditions for the trade.

If you want to learn more about trading vol … and even trade some vol yourself, my Volatility Edge program is what you’re looking for. 

You’ll get access to an entire suite of vol products, weekly volatility-based trades, and right now, Andrew Giovinazzi is guest-starring with a special live series “VIX Made Easy.” Catch up on the classes you’ve missed, and join him live for the rest!

Your Only Option,

Mark Sebastian

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