Predicting Volatility with the VIX (Part 3)

10/01/2009 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

In the last two articles in this series, we talked about the VIX as one of the most effective technical indicators available to traders. The VIX can help you understand changes in risk, option premiums, and market trends. However, the VIX is also a very interesting instrument for traders to profit from. You can essentially trade changes in the VIX through futures, options, or ETNs.VIX

The mechanics of executing a futures, options, or ETN trade are not complicated. If you need a little more explanation, however, you’ll find useful information below, as well as on the Learning Markets Web site.

Although the order entry and analysis process for executing trades based on VIX instruments is relatively straightforward, there are some very unique characteristics that you need to understand before you start making trades. In the video, I will show you why the VIX's tendency to "revert to the mean" creates these unique features.

Futures

There are futures contracts based on the VIX index available for traders with access to a futures trading account. VIX futures are probably not a good idea for novice traders or for traders with a small capital base as each point move in the future's price is worth a $1,000 gain or loss per contract. However, if you are interested in learning more about this contract, visit the CBOE’s Web site to get the official scoop from the CBOE futures exchange.

Options

There are index options based on the VIX available to traders with a standard stock and options brokerage account. You can buy or sell both calls and puts or create spreads, strangles, or straddles like you would a traditional options trade. However, there are a few things to keep in mind when trading VIX options.

1) Because the VIX tends to revert back to the mean, at-the-money calls and puts with the same strike price may have very different premiums. For example, if the VIX is very high everyone knows that it is more likely that it will begin to decline in the near term than rise further and this will make puts much more expensive than calls. The same is true in reverse.

2) VIX calls and puts expire thirty days prior to the next month's expiration of SPX index options. That means that they expire on the Wednesday before or the Wednesday after normal-expiration Friday. This is not a problem for most traders, but it can be confusing if you were expecting a Friday expiration.

3) Option traders investigating VIX options for the first time may find time spreads (calendar spreads, diagonal spreads, etc.) appealing at first glance. However, this is because each month's VIX options are based on a different month's SPX index options expiration date. This distorts these spreads to look much more attractive than they really are. You can dig into the details of why this is and what the risks are, but take our word for it and just don't do it.

ETNs

Exchange traded notes (ETNs) trade like stocks and can be a little easier to manage for new VIX traders than calls and puts. An ETN is very similar to an ETF, and because it trades like a stock, it can be added to the active trading portion of your portfolio easily. Keep in mind that because all market participants know that the VIX tends to revert back from extreme highs and lows, the movements of a VIX ETN will be somewhat less dramatic than the actual movements of the index.

Trading the VIX is easy to do if you are inclined to add it to your list investment strategies. It is easy to analyze and is negatively correlated to a very high degree with stocks, which creates an opportunity to diversify. However, remember that VIX investments have some unique characteristics that make paper trading a must before jumping in and making live trades.

Now, watch the video for more details:

By John Jagerson of LearningMarkets.com.

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