You Can’t Trade The VIX

 

The Option Pit VIX Traffic Light Is Green: Volatility Will Likely Go Up.

Hey Traders,

Today is a shortened trading session …

But we are still seeing plenty of excitement …

COVID fears have spiked the VIX, and the markets are taking it on the chin.

This is not what we are used to seeing during the typical low-volume Black Friday trading session.

Usually on Black Friday, everyone is too busy chasing down the best deals of the year for Black Friday …

Speaking of, as a VIX Edge subscriber, you REALLY need to check out what we’re offering this year … it is the BEST way to take your volatility trading to the next level.

Get the full details here.

And today, in lieu of looking at the quiet VIX pits …

Let’s take a look at why you can’t actually trade the VIX.

The VIX Is Untradeable 

There is one crucial thing that many newbie traders either do not know, or fail to remember …

You can not trade the VIX itself.

Why?

Well, simply put, the VIX does not exist.

The VIX is simply an indicator; it measures forward-looking volatility expectations for S&P 500 (Ticker: SPX) options.

There is nothing to “buy” or “sell.”

It is like other indexes … except the VIX cannot be mirrored by ETFs holding ‘baskets’ of what the VIX is tracking …

So any time we are talking about “trading VIX” we are never talking about the index itself.

Instead …

We are looking at VIX futures, and products based on VIX futures.

VIX futures allow us to trade where we think volatility will be at a certain date in the future.

It is crucial to keep this in mind, because VIX futures do not precisely trade in line with VIX.

They trade at either a premium or a discount to VIX spot price.

As a reader of VIX Edge, you probably know that typically, futures trade at a premium to VIX spot, which is when the VIX futures curve is in contango. 

When futures are trading at a discount to VIX, the VIX curve is in backwardation – so we would see the green VIX line above the futures curve.

Another important thing to remember about VIX futures is they are European-style futures – meaning they cannot be exercised early, and must be held until expiration (which occurs on a Wednesday morning, so futures stop trading at the close on Tuesday).

So you can’t buy a VIX future way in advance, wait for a VIX spike, and then sell to profit. You have to hold onto through expiration.

And the most important thing to know about VIX futures? 

By the time VIX futures reach expiration, they must equal the current VIX.

So if the VIX futures curve is in contango, we will see them decay into expiration, until the equal VIX spot.

In backwardation, VIX futures will actually rise into expiration to meet VIX spot.

VIX exchange traded products (ETPs) likewise do not trade in line with the VIX itself. Instead, they track VIX futures.

For example, iPath S&P 500 VIX Short-Term Futures ETN (Ticker: VXX) tracks VIX futures 30 days out from expiration on a rolling basis (so as the front-month gets closer to expiration, the ETN will rebalance by selling the front month and buying the second month, keeping the average holding at 30 days to expiration).

There is also ProShares Ultra VIX Short Term Futures ETF (Ticker: UVXY), which tracks also tracks VIX futures 30 days out, but on a 1.5x leveraged basis (basically, for every 1 point VXX moves, UVXY moves 1.5).

We might also be getting ready to see new inverse vol ETPs … you can read about that right here.

And of course, there’s options.

Again, when you are trading VIX options, you are NOT trading options directly tied to the VIX index itself.

Instead, VIX options are tied to VIX futures.

So the at-the-money strike for, say, December VIX options, isn’t actually where the VIX is currently trading, but where that VIX future is trading.

You can also trade options on VIX ETPs like VXX and UVXY … but again, these products are tracking VIX futures.

Actually, we trade VXX and UVXY quite a lot in my Volatility Edge program (which we just so happen to be running a Black Friday special on … ahem!).

If played right, VIX ETP options can be HUGELY profitable …

Because …

VIX ETPs track VIX futures …

And because VIX futures are typically (about 80% of the time) in contango (trading above VIX)…

We know VIX futures are usually falling to meet spot VIX …

So ETPs that track VIX futures are ALSO falling …

Look at this one-year chart of UVXY:

That is why I NEVER advise you to buy and hold VIX ETPs like this.

(I explain more here.)

But they can make for some REALLY good options trades in the right conditions …

So remember, when we are trading “VIX” … we are never actually trading VIX proper.

We are trading VIX futures … or products based on VIX futures.

This allows us to speculate on where VIX is headed …

But not actually hold “VIX” itself.

In my Volatility Edge program, we are about to launch an 8-week educational course on VIX Made Easy and VXX Made Easy.

It will help you become a MASTER at trading volatility.

But … it is a members-only live event series.

So you need to join if you want to attend.

Have a great rest of your Friday … and enjoy your weekend.

Your Only Option,

Mark Sebastian

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