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How to Trade the VIX

01/16/2013 11:30 am EST


Lawrence McMillan

Founder & President, McMillan Analysis Corporation

There are a lot of moving parts to simply trading this volatility index and if you don't know them you can't trade effectively, says veteran trader, Larry McMillan.

My guest today is Larry McMillan.  We're talking about ways to trade the VIX.  You can't trade the VIX outright, they are derivatives to use, so Larry, let's talk about some of the best ways to trade around the VIX?

Right, well, it all boils down to just two products; VIX futures and VIX options.  There are plenty of ETFs and ETNs, mostly ETNs, out there, exchange traded notes, and the note is a little bit different from an ETF, because in an ETF there are actual underlying, say stocks, that are put into like a trust, and then that's the backing for the ETF. 

In a note it's not that way, it's just the full faith and credit of the issuer, so technically subordinated debt of the issuer, so in volatility trading, VXX, is going to be an ETN, and that's a Barclay's issue, so Barclay's makes a ton of money and has a ton of money.  It's not really a risk problem, but you should be aware of that, anyway. 

Anyways, the VXX, they actually trade the future.  So, you buy VXX and you can buy that in an IRA account or anything like that.  Barclay's then goes out and trades the futures.  They are buying actual VIX futures and they're rolling them every day, so it's a weighted combination, which you don't really have to concern yourself with too much, but when the futures do get expensive as they are right now, you're overpaying for your VXX, so VXX will not perform maybe as well as you might have hoped.

Why are the futures getting expensive?

Because everybody's buying them.  It's a "chicken and the egg" thing.  Everybody thinks right now the greatest trade is to buy stocks and buy volatility as protection, and it's not a bad trade, and if we have a real disastrous 2008 thing again, then it will work, but if you just have a modest correction in the stock market, you're probably not going to get the protection you'd hoped for out of volatility right now at this point in time.  You know, it'll change.  There will be another time when it's cheaper, but right now protection is expensive because everybody wants it, and it's sort of a, you know.

Is it just a matter of the fact that it's been so low for so long that people think it's got to go up, and so I'm going to buy the VIX?

Well, right, but I mean, I think that, but I think the more sophisticated people are also buying stocks at the same time so that they're hedging their bet, you know.  In other words if the stock market continues to go up then, fine, I'll lose something on my protection and I don't really care, but if stocks tumble I want something that is going to make some money for me. 

So, you might just say, "Well, why not just buy SPX puts like we all used to, but there are a number of things that don't work so well with that, including the dynamics of it.  If you do that and the market goes way up, your put strike is garbage, just down there doing nothing, but if you own volatility, no matter when the bad times start to happen in the stock market, volatility will kick in and your volatility product will then work for you even if it's been a while since you bought it.

So what do you recommend for people that want to trade around the VIX?  Is it the futures options, or the ETFs?

Yeah, well, I prefer the options because I'm an option guy, you know, but you really have to stay short-term, because it won't perform like VIX otherwise, and VXX is short-term, again, you might not realize that, but they're just trading the two front-month futures, the two shortest term futures. 

So, what we recommend to people is they buy out-of-the-money VIX options as a hedge against their stocks, and so you don't want to spend a lot of money on the protection but, you will, over the course of a year, if you keep doing that and you don't use it, it'll probably cost you 3% on your portfolio or something like that, which, it sounds like a lot if you're in the relative performance business, but if you're just a guy trying to protect his portfolio, that's not too bad.

And how about weeklies?  Are there weekly options around the VIX?

There are.  They're not as popular, but they're definitely there.  I mean, that's, you know, if you want to readjust every week, that's fine.  My personal feeling is weekly options are for selling, not buying, but you know.

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