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Volatility ETFs Can Be Used To Make Money In The Stock Market During Selloffs
The holy grail of stock trading is finding a way to make easy money in the stock market without exposing a brokerage account to excessive risk, so stock trading profits can be made without losing sleep at night. People pay thousands of dollars for stock market advice and trading systems with the goal of making easy money in the stock market. The following volatility trading strategy that uses instruments that track stock index volatility is not only an easy way to make easy money in the stock market, but can also be utilized to hedge against unexpected events that from time to time cause the stock market to sell off sharply, so long stock position losses are offset by volatility instrument gains.
Making Easy Money In The Stock Market Trading Volatility On The Long Side
By now, anyone who follows the stock market on a regular basis has likely heard of the Chicago Board Options Exchange (CBOE) Market Volatility Index (Symbol: VIX). The VIX is a measure of implied market volatility over the upcoming thirty (30) calendar days, based upon how much options traders are paying for options contracts in the options markets to protect their long positions against market downturns (see: How to Trade Options).
While the VIX cannot be traded directly, and is only a barometer that indicates how much stock market traders and investors are willing to pay for options to protect their long stock positions at any given moment, there are a number of exchange traded funds (ETFs) that derive their value from the trading level of options that trade generally in tandem with the VIX. These volatility ETFs can be freely traded by anyone with a regular brokerage account (no options trading account is necessary) to trade stock index volatility, with the goal of making a profit.
Like any other stock market trading strategy, trading volatility ETFs is a matter of timing, as getting in and out at the right times can be the difference between a profit and a loss. Trading ETFs that derive their value from options associated with the VIX has very clear parameters regarding when to buy, so the buying side of the equation is very straight forward and easy to implement. When to sell is a matter of trader preference and how one reads a stock market selloff in regards to its potential longevity and depth, as a longer and steeper selloff is likely send volatility based ETFs higher.
When the stock market is in rally mode, the VIX typically falls below 20, which indicates that stock traders and investors are not worried about a sell off and are not willing to pay a lot for options to protect their long stock positions, as they expect the stock market rally to continue for the foreseeable future. When the VIX falls below 20, and all is well in the stock market, it is time to consider buying ETFs that derive their price from volatility options associated with the VIX. If a stock rally is particularly strong, the VIX may fall below 15, which indicates complacency prevails in the stock market. How long the VIX stays below 15 is anyone's guess, since stock rallies and complacency can last a long time; however, a VIX below 15 can be a good time to buy ETFs that derive their price from volatility options in anticipation of future stock index volatility.
Once volatility ETFs have been purchase, the volatility ETFs trade becomes a waiting game for a steep stock index sell off. When the market experiences its next bout of turmoil and sell off, stock traders and investors will bid up the price of volatility options contracts to protect their long positions against market downturns, which in turn will send the volatility ETFs up in price. It is at this point that a trader should consider selling ETFs that derive their price from options associated with the VIX. When to sell is a matter of trader preference and one’s read regarding how bad the market sell off may be.
The severe economic crisis that occurred in the fall of 2008 sent the VIX above 80, with lesser spikes in the VIX to the mid 40s, due to stock market turmoil during 2010 and 2011. Long-oriented volatility ETFs reacted to the spikes in the VIX with huge price increases that provided opportunities to sell volatility ETFs for considerable profits.
Making Easy Money In The Stock Market Trading Volatility On The Short Side
Stock market traders can make money when stock market volatility decreases (i.e., the VIX is falling) by purchasing an inverse VIX financial product called VelocityShares Daily Inverse VIX ST ETN (NYSE: XIV). XIV goes up in value when the VIX falls (and drops in value, when the VIX rises).
Volatility ETFs can also be played on the short side to make money on a falling VIX by borrowing shares of volatility ETFs (if available) when the volatility ETFs are trading at high prices, selling the borrowed volatility ETFs shares short at high prices, then waiting for market volatility to settle down, and the VIX and volatility ETFs to fall in price. To profit, a trader would eventually purchase the volatility ETFs shares at a lower price and return the borrowed volatility ETFs shares to their rightful owner.
These strategies of either buying an inverse VIX product such as XIV or playing Volatility ETFs on the short side is based on the assumption, which is a fair assumption to make, that no matter how dire the stock market and economy look at a given moment in time, things will eventually improve and the VIX and Volatility ETFs will respond to the better stock market and economic conditions by falling to price levels that are consistent with a bullish stock market and good economic times, which typically sends the VIX below 15.
Using Volatility ETFs To Hedge Against Stock Market Downturns
The steep stock market sell off during the fall of 2011 is a good example regarding how volatility ETFs can be used to hedge against downturns stock indexes. While many traders and investors incurred losses during the second half of 2011, as the European Debt Crises caused stock markets around the world to enter sharp and painful sell offs, those holding volatility ETFs were able to lessen their losses since the value of their volatility ETFs holdings increased in value tremendously as stocks and other stock-based financial instruments lost value.
Volatility ETFs Available For Trading Volatility
The following is a partial list of volatility ETFs that are available for trading. It is important to note that some of these volatility ETFs are leveraged ETFs, meaning that they move at two times the amount of the options contracts associated with the VIX.
Volatility ETFs For Playing VIX On The Long Side
- ProShares Trust VIX Short-Term (Symbol: VIXY) - The investment seeks to provide investment results (before fees and expenses) that match the performance of the S&P 500 VIX Mid-Term Futures Index.
- ProShares Trust VIX Mid-Term Futures Index (Symbol: VIXM) - The investment seeks to provide investment results (before fees and expenses) that match the performance of the S&P 500 VIX Mid-Term Futures Index.
- Velocity Shares Daily 2x VIX Short Term (Symbol: TVIX) - The investment seeks to replicate, net of expenses, the returns of twice (2x) the daily performance of the S&P 500 VIX Short Term
- VelocityShares Daily 2x VIX Med (Symbol: TVIZ)- The investment seeks to replicate, net of expenses, the returns of twice (2x) the daily performance of the S&P 500 VIX Mid-Term Futures index.
Volatility ETFs For Playing VIX On The Short Side
- ProShares Short VIX Short Term (Symbol: SVXY) - The investment seeks to replicate, net of expenses, the inverse (opposite) of the return of the S&P 500 VIX Short-Term Futures index for a single day.
- iPath Inverse S&P 500 VIX Short (Symbol: XXV) - The investment seeks to replicate, net of expenses, the inverse (opposite) performance of the S&P 500 VIX Short-Term Futures index Excess Return.
- VelocityShares Daily Inverse VIX Mid-Term ETN (Symbol:ZIV) - This investment offers inverse (opposite) exposure to an index comprised of VIX futures, but focuses on a benchmark comprised of securities with mid-term maturity.
Words of Caution Regarding Trading Volatility ETFs On The Long Side
It should be cautioned that while trading volatility ETFs on the long side (expecting them to go higher) is a relatively safe and easy way to make money in the stock market during times of volatility, this trading strategy can be ineffective during sustained bull market rallies in stocks. In 2010, 2011, and 2012, the VIX bottomed in the 14 to 20 range, which provided some excellent money making opportunities for those who bought volatility ETFs during periods of stock market complacency and sold them during stock market turmoil. However, during the historic 1990s bull market rally, the VIX approached 10 and remained in the low teens for a number of years, as stocks enjoyed bullish sentiment for a number of years. Holding volatility ETFs during sustained bull market rallies in the stock market ties up investment capital that could potentially be deployed elsewhere in the stock market more effectively. Therefore, it is a good idea not to commit too much money to buying and holding volatility ETFs, but to rather use them as just another way to trade the stock market and diversify one’s investments to make money when volatility picks up, and to hedge against market downturns.
It is important to note that while volatility ETFs can be used to make easy money in the stock market during periods of stock index turmoil, some financial advisers warn against buying volatility ETFs and holding them long term, due to the potential for price decay in the value of the volatility ETFs over time during flat and bull markets. Price decay occurs when the further out month’s futures and options contracts that volatility ETFs use to derive their value are more expensive than the current month’s contracts, something known in stock market parlance as contango. When the current month’s contracts expire during contango situations, volatility ETFs must buy the more expensive further out month’s contracts to maintain their positions, thus causing the ETF to lose value. The performance of the various volatility ETFs has varied considerably during flat and bull markets, and therefore research regarding the price action of volatility ETFs that one is considering purchasing during flat and bull markets is a good way to limit potential losses from holding volatility ETFs.
While volatility ETFs are relatively new stock market instruments, they have already proven to be excellent vehicles for making easy money in the stock market when bought and sold at the right times. Good timing, patience, and an occasional bout of stock index turmoil and steep sell offs is all that is needed to make easy money in the stock market via volatility ETFs.
Disclaimer: This article was not written by a financial professional or a registered financial advisor. This article is for informational purposes only, and is not intended to be solicitation or recommendation to purchase any ETFs or securities mentioned herein. Please consult a registered financial advisor to ensure you understand the risks and rewards associated with buying and selling ETFs, mutual funds, and other financial products that derive their value from market volatility.
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This content reflects the personal opinions of the author. It is accurate and true to the best of the author’s knowledge and should not be substituted for impartial fact or advice in legal, political, or personal matters.
© 2012 John Coviello
John Coviello (author) from New Jersey on January 15, 2016:
The ETFs that increase in value as volatility increases have done very well since the start of this year. Don't know when the stock market will turn around and when they will fall back, but the strategy of buying volatility ETFs has worked in early 2016. Once the market settles, money can be made using an inverse volatility ETF, such as XIV.
Glenn Stok from Long Island, NY on October 27, 2013:
You explained the VIX very well. Volatility can also be used with regular options to put the odds in your favor a little better than 50/50. I guess that's what you mean by "easy money."
I sell options short when the implied volatility percentile is high for a particular stock. The option premium tends to erode when volatility goes down again, usually after a binary event such as earnings announcements. This can give one an advantage to make a profit even if wrong with the direction, as long as the underlying stock doesn't move too far in the wrong direction.
John Coviello (author) from New Jersey on August 07, 2013:
I agree that trading volatility ETFs needs to be done carefully and certainly risks are involved, but I don't avoid providing warnings regarding the risks involved in these trades. See the section of the article called, "Words of Caution Regarding Trading Volatility ETFs On The Long Side". In that section I give the same warnings that you just gave. There is a tendency for volatility ETFs to lose value over time and should not be bought and held for long periods of time. But, when bought when the VIX is extremely low, more often than not, holding them short term results in a short term profit.
Just look at what has happened the last few days. The VIX goes below 12 for the first time in 6 months, and is now surging on market volatility, and volatility ETFs are responding by moving higher. That is how this trade is easy money. A patient trader that buys volatility ETFs when the VIX is extremely low has a good chance of making easy money. Not guaranteed, but nothing is guaranteed in the stock market. Borrowing from your gambling analogy, it's just a matter of tilting the odds in your favor.
Marc on August 07, 2013:
VXX dropped in value by 45% in the last 6 weeks.
It is very dangerous to listen to this advice if you are new to this concept of volatility. If you are novice with volatility ETFs do not buy any of them until you have done all a lot of homework and you completely understand what is contango and backwardation and what causes contango to increase or decrease. It is imperative that you fully understand it before committing your money to a trade or investment.
There is no such thing as "easy" money as this article implies. You can make solid gains if you time it right but the amount of knowledge and understanding required to do it safely is very significant.
This is about as "easy" as winning at blackjack. You need to know when to hit, stand, and double down. You also need to know which cards are more likely to come up next.