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The Good, the Bad, and the Ugly in Trading Volatility

Chad Karnes

Last week I wrote an article (here) on a potential VIX set up that is playing out right now.  The VIX has helped us spot short term market tops in the past and can be traded using VIX exchange-traded products (ETPs).  But, there are some nuances in trading the VIX that need to be addressed before jumping into a volatility investment.  Some of them are good, some bad, and some are really ugly.

The Good

One great aspect of trading the VIX is there are a lot of different ways to capitalize on potential opportunities for investors, traders, and hedgers alike.

The Traditional - You can take advantage the old fashioned way and use futures or option strategies such as Straddles or Delta Neutral Spreads.  This would likely provide the most correlated trade with volatility and allow for direct, measurable, and fine-tuned strategies.  Futures and options are usually considered risky, can be convoluted, and are definitely not for all investors, though.  This strategy would likely work best for a longer term sophisticated investor looking to hedge his or her portfolio. 

The Roundabout - You could trade the S&P 500 based on the VIX signals.  Typically the VIX will behave inversely to the S&P 500.  When the VIX is up, the S&P (SPY - News) is usually down, and vice versa.  But, this is not always the case.  There are many examples when both the VIX and the markets (VTI - News) are up or down together.  A majority of the time, though, especially on days with big market moves, they move in opposite directions.  This is the reason the VIX is often referred to as the fear trade, as it typically rises when markets sell off.

The Adapter - The best part about the VIX today is that there are numerous ETPs that track volatility and allow individual investors to take advantage or hedge moves in future volatility expectations. But they all also come with a lot of baggage that can kill an investment if they are not properly understood or executed.

A Plethora of Volatility ETPs

Each year there are more and more volatility ETPs being added and today there are well over 15 different choices.  The major differences between them all typically involve which exchanges they trade on, which banks control the underlying assets, their fund structures, and the amount of leverage utilized in their tracking. 

For instance the ProShares VIX short-term futures ETF (VIXY - News) is an unlevered ETF that attempts to track the short term (one month) VIX by investing in VIX futures.  In contrast the Horizons BetaPro S&P 500 VIX Short Term Futures Bull Plus ETF (HVU.TO - News) is a 2x levered ETF that trades on the Toronto Stock Exchange and also invests in VIX futures.  A very similar US Exchange version is the ProShares Ultra VIX Short-Term Futures ETF (UVXY - News).

The Bad   

The bad thing about all of these ETPs is they don't track the popular underlying $VIX Index (^VIX - News) all that well.  The chart below shows two of the popular VIX ETFs, the VIXY and the VelocityShares VIX Short Term ETN (VIIX - News).  Since the beginning of this month through 9/20, the tracking error is showing a 1.5% difference!  The VIXY and VIIX behave basically identical, but they don't do the best job of tracking the VIX Index's movements and were already 1.5% behind for the month. 

Days like Thursday, 9/20, when the VIX was up 1.37% is a great example of how these instruments can fall behind over time.  The VIXY was up most of the day along with the VIX but actually finished down 1.06% on some end of the day selling.  The VIX finished up 1.37% that same day.  Sometimes the VIXY will outperform the VIX while other days the VIX is the one outperforming, which the chart above helps put into perspective.  

Over short periods of time the volatility ETPs typically perform similarly to the VIX (like the 13 days shown above), but there will be hiccups along the way when one will rise or fall faster than the other (like on 9/20).  Unfortunately this seems like something that traders of volatility ETPs will have to accept over the short run, that is until a better alternative is created. 

The Ugly

A 1.5% tracking error over the course of a few weeks may be acceptable given the kind of volatility the VIX index has, but that amount increases greatly as time goes on.  The year to date difference between the ETPs, after fees and other nuances associated with their inner workings and structure, compared to the VIX is an inexplicable 35%.  The VIX is down 40% since its beginning of the year print, but the ETPs that supposedly track the front month volatility (VIX) are down over 75% year to date.  That is unacceptable and a major warning for investors to NOT hold these products longer than a few days.  The chart below puts the tracking error and fee deterioration into perspective.


The levered VIX products, just like the other levered ETPs available to investors, also have the well known "time decay issue" to add to their tracking error.  The below chart of the VelocityShares Daily 2x VIX ST ETN (TVIX - News) puts the tracking error and time decay into perspective with a 55% Year to Date difference.

The VIX can be helpful in spotting market turning points through its inherent complacency and fear measures of the market.  But, in order to trade volatility specifically through ETPs, an investor must be nimble and willing to accept short term hiccups and imperfect tracking.  The VIX ETPs can be used to trade volatility over short periods of time (a few weeks max), but they should not be held for any longer.  They are made strictly for trading and not for longer term portfolio holdings.

Each month the ETF Profit Strategy Newsletter, and a few times a week via the Technical Forecast, we use key indicators like the VIX to identify high probability trading setups for the S&P 500, the VIX, and ETFs linked to major asset classes. 

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