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Newbie Lessons Learned from Trading Volatility using the VXX and VXZ ETNs

Posted on | June 4, 2010 | No Comments

I’ve been experimenting with trading volatility on the stock market using ETNs like VXX and VXZ. I learned a few things in the process, and since a few people were curious about this idea and I thought I’d post my learnings for the curious.

VIX volatility index versus the VXX and VXZ ETNs

A couple of months ago I realized that I wanted to make a bet against the market, which I suspected was over-priced and ignoring some series macro problems. Buying an index fund tied to the S&P500 was not what I wanted to do — I wanted to bet that the S&P500 was in for a ride and a correction.

It turns out that the volatility of the market is captured in an index called the VIX. When volatility goes up, the VIX goes up and vice versa. I wanted to bet that the volatility, which had been declining for months as stocks steadily rose, would spike when investors realized the market wasn’t the utopia valuations suggested.

But how to make this trade as a newbie? There are options tied to the VIX you can buy (or sell), but I had a feeling that as someone who barely understands the mechanics of publicly traded stock options I’d screw up the mechanics of the option trade and lose out. I needed something simple.

As it turn out, Barclays offers two ETNs which are designed to follow the VIX: VXX (short term VIX futures) and VXZ (mid-term VIX futures). Ah! I could buy one of these ETNs like a normal stock, wait a bit, then sell when the market volatility increased. Simple enough.

I made the move. I bought some VXX earlier this year, which I sold recently as the market panic over PIGS hit the Wall Street Journal front page. Mission accomplished! Well, sort of. I did ok, but thought this trade would have been a lot more profitable than it was, since the timing was pretty on target. Here’s what I learned:

1) The VXX and VZX ETNs don’t match the VIX very closely. Often, the VXX ETF went up only half as much as the VIX did during a move. The VXZ was similarly erratic. This is mainly because the ETNs follow the futures market, not current volatility. But don’t underestimate how much this affects the behavior of each ETN — they do not behave much like the VIX itself at all.

2) Choose the right ETN: VXX versus VXZ. This year, the VXX declined more steeply than the VXZ. I suspect it’s better to short the VXX when you think the market is going to stabilize, and buy the VXZ when you think the market is going to destabilize. Check out the graph.

3) Remember that volatility is likely to revert to the long term mean. For the VIX itself, that mean is ~18 which is much lower than the current value of ~35. The good news is that the VIX isn’t going to go to 0;there is always some volatility. But I don’t recommend buying volatility when it’s already high; it’s likely to decline steadily for a while until the next crisis and in the mean time you’re going to sweat.

4) Consider using the VIX as a way to time the market. When the VIX spikes, it’s likely equities are in free fall so you may be buying at the bottom. Everyone just panicked and bought treasuries and gold as they ran for cover. When the VIX is low, the market is probably blissfully ignorant of some problem and things are over-bought. Time to sell. A future project is to backtest this idea a little to see how this idea really works.

I do think there are uses for the VIX-related ETNs, but it’s not a simple as I thought it would be. If you know what you’re doing, VIX options might be a better choice than the ETNs because you’ll be able to capture more value from volatility spikes. Regardless, this gave me something better to do than investing in gold and treasuries when I’m feeling bearish.

Caveat lector! I’m not in any way a trained investment professional, and you definitely should not take any of the above as investment advice. Hopefully, it’s at least entertaining.

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