Posted on 26 October 2013.
With the Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX) a household term that is widely known these days, many stock market investors and traders wonder how to make money trading stock market volatility. The VIX is an instantaneous measure of how much options traders are willing to pay for put and call options that are written against the Standard and Poors 500 (S&P 500) stock market index. S&P 500 index options are priced in part based on stock market volatility expected in the near-term. Higher volatility expectations lead to higher options prices, since the likelihood of the options reaching their target price by the time they expire increases when large moves and volatility are expected in the S&P 500 index. As a result, the parties that sell S&P 500 index options raise the prices they sell the options for to cover the increased risk that they may have to pay the buyers of the options upon expiration. This causes the VIX to increase since it is based on the price of S&P 500 options.
It is important to understand that the VIX is only a gauge of put and call option buying activity, and is not a financial security that can be traded directly. In other words, you cannot use an online brokerage account to buy and sell the symbol VIX. There are options written against the movement of the VIX that can be purchased, but that is beyond the scope of this article. What can be traded via an online brokerage account to make money trading stock market volatility is a variety of exchange traded funds (ETFs) that mimic the VIX by buying VIX options and related financial instruments that obtain their valuation based on the level of the VIX. VIX ETFs are designed to rise or fall based on the movement of the VIX. The direction they move in depends upon whether they are designed to be bullish on the VIX (go up when the VIX goes up) or bearish on the VIX (go up when the VIX goes down).
The way to make money trading the VIX when one expects stock market volatility to increase is by purchasing an ETF that goes up in value as the VIX increases. Volatility ETFs derive their value by using options and other financial instruments to mimic the increase of the VIX. These ETFs come in forms that range from a one to one ratio to a two to one ratio, meaning when the VIX goes up 10% during a trading session, the one to one ETFs should increase 10%, whereas the two to one (or double) ETFs should increase 20%. Unfortunately, in reality the VIX ETFs do not always perform as they are designed to perform during a trading session, so traders cannot always expect the double VIX ETFs to provide double the returns of the one to one ratio VIX ETFs. However, the ones that are designed to move by double the movement of the VIX will move more than the one to one ETFs, so if one is expecting a short term spike in volatility, the double VIX ETFs are the best way to make money.
Money can also be made one when expects stock market volatility to decrease by purchasing an ETF that goes up in value as the VIX decreases (a short oriented VIX ETF) or by establishing a short position in a long oriented VIX ETF. Stock market volatility and the VIX will fall after an event that causes the VIX to spike has passed, creating an excellent opportunity to make money on the short side of the stock market volatility trade.
The important thing to understand about trading volatility is that timing is crucial. Unlike buying a stock, which can recover in price over the long run, if a trade does not work out as intended, long oriented ETFs designed to mimic the VIX lose value slowly over time. They are useful for short-term volatility trading only and should never be held for long periods of time.
The following are some of the long oriented volatility ETFs that are designed to increase in price as the VIX increases in price. Some of these volatility ETFs are designed to move two times the movement of the VIX.
The following are some of the short oriented volatility ETFs that are designed to increase in price as the VIX decreases in price. All short oriented volatility ETFs are one to one ratio ETFs.
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