ETFs

The VIX has provided us with some great trading profits over the past six months, but volatility linked exchange-traded products remain a risky venture, writes the Chad Karnes at ETFGuide.com, so he prefers using VIX options to hedge rather than hit-and-miss ETPs.

Given the VIX's recent decline to six-year lows, and potential profit setups that now abound, it is time to revisit some of the key things to know in trading volatility.

Recently I wrote an article about a potential VIX trade setup that is playing out right now. The VIX has helped us spot short-term market tops in the past, providing great volatility trade setups that can be taken advantage of using traditional options or the newer VIX exchange-traded products (ETPs).

But there are some nuances in trading the VIX that need to be addressed before jumping into a volatility investment. Some of them are good, some are bad, and some are really ugly.

The Good
One great aspect of trading the VIX is there are a lot of different ways to capitalize on potential opportunities for investors, traders, and hedgers alike.

  • The Fear Trade - You could trade the S&P 500 (SPX) based on the VIX signals. Typically the VIX will behave inversely to the S&P 500. When the VIX is up, the SPDR S&P 500 Trust (SPY) is usually down, and vice versa. But this is not always the case. There are examples when both the VIX and the markets are up or down together. A majority of the time, though, especially on days with big market moves, they move in opposite directions. This is the reason the VIX is often referred to as the fear trade, as it typically rises when markets sell off.
  • More Traditional - You can take advantage the old-fashioned way and use futures or option strategies such as straddles or delta neutral spreads. This would likely provide the most correlated trade with volatility and allow for direct, measurable, and fine-tuned strategies. Futures and options are usually considered risky, can be convoluted, and are definitely not for all investors, though. This strategy would likely work best for a longer-term sophisticated investor looking to hedge his or her portfolio.
  • Adaptation - The best part about the VIX today is that there are numerous ETPs that track volatility and allow individual investors to take advantage or hedge moves in future volatility expectations. But they all also come with a lot of baggage that can kill an investment if they are not properly understood or executed.

A Plethora of Volatility ETPs
Each year, there are more and more volatility ETPs being added and today there are over 15 different choices. The major differences between them all typically involve which exchanges they trade on, which banks control their underlying assets, their fund structures, and the amount of leverage utilized in their tracking.

For instance the ProShares VIX Short-Term Futures ETF (VIXY) is an unlevered ETF that attempts to track the short-term (one month) VIX by investing in VIX futures. In contrast, the Horizons BetaPro S&P 500 VIX Short Term Futures Bull Plus ETF (HVU) is a 2x levered ETF that trades on the Toronto Stock Exchange and also invests in VIX futures. A very similar US exchange version is the ProShares Ultra VIX Short-Term Futures ETF (UVXY).

NEXT PAGE: The Bad & Ugly

Tickers Mentioned: Tickers: SPX, SPY, VIXY, VIX, TVIX