Posted on 09 March 2012.
An increasingly popular way to make money in the stock market is to trade stock market volatility. Understanding how to trade stock market volatility will not only provides traders new potentially profitable trading opportunities, but can also provide protection against unexpected events that cause stock market volatility and sell offs.
There are two ways to trade stock market volatility: buying volatility call and put options and volatility exchange traded funds (ETFs). Volatility options are options that derive their value from the price and movement of the Chicago Board Options Exchange (CBOE) Market Volatility Index (Symbol: VIX). Volatility ETFs derive their value from the price and movement of volatility options pegged to the movement of the VIX.
For sophisticated traders who have options trading accounts and understand options trading (see: Option Trading Basics), buying volatility call and put options may be the best way to trade stock market volatility. This is because volatility options that derive their value from the price and movement the VIX are the purest way to play market volatility. A trader can profit from the actual price movement in the VIX by buying volatility VIX call and put options without having exposure to the other financial instruments that comprise volatility ETFs.
Average individual investors can trade stock market volatility, without using options or an options trading account, by buying either long or short oriented volatility ETFs. Long oriented volatility ETFs can be brought while volatility is low to profit from volatility spikes. Short oriented volatility ETFs can be brought while volatility is high to profit from volatility selloffs.
Two volatility ETFs that are available for trading volatility on both the long and short side are: Velocity Shares Daily 2x VIX Short Term (Symbol: TVIX) for trading volatility on the long side and ProShares Short VIX Short Term (Symbol: SVXY) for trading volatility on the short side. Volatility ETFs are a relatively safe way to play volatility in the stock market; however, during bull markets when volatility is low, long oriented volatility ETFs can lose value over time due to option price decay, which should be kept in mind by traders looking to protect their trading capital.
Before starting to trade stock market volatility, it is important for traders to understand what volatility options and volatility ETFs are based upon, which is the CBOE Market Volatility Index (VIX). Volatility options and volatility ETFs generally track the movement of the VIX in either a positive or negative direction, based on their long or short orientation. The VIX is defined as a measure of implied market volatility over the upcoming thirty (30) calendar days. In plain English, the VIX reflects how much options traders are paying for options contracts to protect their long positions from market downturns.
To effectively trade stock market volatility, it is important to understand that timing of the volatility trade is paramount. When the VIX is trading below 20, it is time to consider buying long orientated volatility options and volatility ETFs, for a potential future spike in the VIX and increase in the associated long volatility options and volatility ETFs. When the VIX has spiked higher during a stock market selloff or panic, and is trading above 40, it is time to consider buying short orientated volatility options and volatility ETFs, for a potential future drop in the VIX and increase in the value of short oriented volatility options and volatility ETFs.
The stock market volatility trade should be used sparingly and in moderation for times when the VIX reaches oversold and overbought levels. It should be noted that the VIX can stay at oversold and overbought for long periods of time; therefore, it is recommended to trade stock market volatility with a great amount of patience.
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