• Understanding Market Volatility

  • market-volatility-150x150While most investors are scrambling to figure out whether the stock market is headed up or down, savvy pros use the VIX both as means of protection and a source of profit.

    The VIX not only gives you an idea of how uneasy people are about the stock market, it tells you whether or not the markets have reached an extreme level of sentiment – either bullish or bearish.

    That’s why knowing how to stock trade the VIX is so essential.

    But before we get into how to stock trade the VIX, we need to understand what the VIX actually is.

    What the VIX Indicator Measures

    Most investors think of the VIX simply as a “fear gauge.” But the VIX doesn’t measure actual stock market volatility. In fact, experts view the VIX as possibly one of the best contrarian indicators in the business.

    You see, the VIX tracks the stock trading in options on the S&P 500 to indicate how investors expect the market to move over the next 30 days.

    As investors buy more put options, they get more expensive and the VIX goes higher. Conversely, the reverse is also true: when investors sell options, they become cheaper and the VIX begins to fall.

    The VIX then, is really a reflection of the price of calls and puts on the S&P 500.

    It is quoted in percentage points and roughly translates to the expected annualized movement in the S&P 500 over the next 30 days. A VIX reading of 15 implies the S&P could swing higher or lower by 15% over the next 12 months, or about 4.33% over the next 30 days.

    As a contrarian indicator, the VIX usually has an inverse relationship with the markets. When the market is rallying the VIX tends to drop; when the market is tanking the VIX tends to rise.

    The scarier the broad market decline the higher the VIX tends to go – hence its reputation as the “fear gauge.”

    A VIX reading greater than 30 is generally associated with a large amount of volatility and uncertainty, while values below 20 generally reflect less stressful times. The index has a 20-year average of 20.43.

    During the worst part of the 2008-2009-market collapse the VIX soared as high as 80!

    The one question that continuously comes up regarding the VIX is this:

    If there’s fear in the marketplace – and traders are buying puts and their prices are increasing, and they are selling calls and their prices are decreasing – why don’t the two cancel each other out and the VIX react less dramatically?

    The answer comes in two parts.

    First, “selling calls” is a hedge against falling stock prices. But when you sell calls against a position you hold, you only collect the “premium” or payment that you sold the calls for. No matter how far the stock falls, your downside protection is limited to the money that you collected for selling the calls, meaning this hedge has limited value.

    On the other hand, by “buying puts,” you can hedge or profit from a steep-and-lengthy drop in the price of the underlying stock market. That’s why volatility spikes in fearful markets.

    Buying Stock Market Insurance

    Even though the VIX measures options trading, dealing with the VIX doesn’t have to be complicated.

    Think of the VIX as insurance for your investments. Like housing or car insurance, when an asset (stocks) you own is damaged or even destroyed, you are reimbursed.

    What’s even better with the VIX is that it can be used to not only protect your investments, but as a great profit tool as the market increases in volatility.

    The key is knowing how and when to use the VIX. All you need is the right guidance.

    When the VIX is trading below 15, investors need to protect themselves against potential volatility.

    The low VIX creates an excellent opportunity for you to buy put protection at reasonable prices, in the face of future unknowns, and as long as implied volatility is low, you should take advantage of cheap puts to add some portfolio protection … just in case.”

    Investors who heeded his advice in the past are glad they did.

    How to Trade the VIX

    There are a few different options for investors who want to know how to trade the VIX when market volatility surges.

    And with the VIX recently trading as low as 11 and still in the mid-teens, now is a great time to play the VIX.

    It’s only a matter of when.

    The simplest approach to trade the VIX is through VIX futures-based exchange-traded notes (ETN) and exchange-traded funds (ETF), including the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ).

    Because they are cheap to own and trade, they make for a fairly good, simple alternative for investors looking to hedge their risks and protect their profits. Any worries about the central bank “tapering” back on bond purchases, a realization that the bull market in stocks is over, or any news that could cause stocks to fall is going to contribute to escalating levels of investor fear. That’s going to cause the VIX to spike – and the VXX and VXZ with it.

    Most often, the movements in the VIX are inversely correlated to the S&P 500 and the market in general.

    That means trading S&P 500 equities with plenty of liquidity.

    When the VIX is high you can buy the S&P 500 SPDR (NYSE: SPY), an ETF that tracks the S&P 500.

    And when the VIX is low (below 20), consider a number of leveraged inverse ETFs, including the ProShares UltraPro S&P 500 (NYSE: UPRO) and the ProShares UltraShort S&P 500 (NYSE: SDS).

    For stock traders of the VIX, holding positions for big moves can sometimes be foolish and needs to be combined with other trading disciplines. Until the VIX stops trading in narrow bands, traders should take smaller profits and be quicker on the trigger when their trades are in the black.

    Although the VIX is a stock market volatility index, traders and investors need to understand that it’s really no different than any other investment instrument – meaning that it, too, is vulnerable to structural changes and the dynamics of constantly moving market expectations.

    You should always understand what’s going on with the instruments you invest in and trade … and avoid at all costs getting blindsided by moves that you could have anticipated.

    Investors who want to trade the VIX should keep in mind that it is one tool and needs to be combined with other disciplines but does offer a critical piece in understanding the current market sentiment.