Editor's note: In this week’s Swim Lessons? column, co-host Scott Connor outlines a few different ways investors can trade volatility. To learn more about this topic, TD Ameritrade clients can join Swim Lessons? in the thinkorswim platform on Wednesday April 5th at 10:30 AM CT for “Trading Volatility with VIX Options”.
If history has taught us anything, it’s that market uncertainty can almost always be expected. However, in Swim Lessons?, we like to say that a little volatility can actually be a good thing for traders, especially if you’re prepared. So, the next time a storm of volatility and uncertainty comes rolling into the market, make sure you know your options.
You might be able to catch a wave or two.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
Volatility as an Asset Class? To-may-to, To-mah-to
There's been an argument brewing over the last several years, perhaps a bit obscure, as to whether volatility should be considered an asset class in its own right. No matter where you stand on the issue, some facts seem irrefutable:
- In general, there is an inverse correlation between the VIX and the stock market. When the market drops, fear and uncertainty tend to rise.
- Inversely correlated investments, like an “Inverse ETF,” can be used to potentially provide balance and diversification to a portfolio, especially during periods of uncertainty. However, these products are subject to unique risks due to their use of derivative positions, require active monitoring and management (as frequently as daily) and are not suitable for all investors.
- A number of tradable and investable volatility products exist— such as options, futures and other exchange-traded products (ETPs).
So, is volatility an asset class? If you're comfortable using volatility products to help you pursue your objectives, does it matter?
The VIX is a reference rate— an index made up of the implied volatilities of a basket of short-term options on the S&P 500 ($SPX), normalized to a 30-day constant maturity. As such, you can't trade the index directly. But if you want that volatility exposure, you do have choices.
VIX Futures. One way to get volatility exposure is to consider VIX futures, which are simply the market's anticipation of where the VIX will be at monthly points in the future, as shown in figure 1. VIX futures are cash-settled, with a final settlement value equal to $1,000 times the settlement price. So, for example, if you buy a VIX futures contract for 15, and it drops to 14, you’ll be down $1,000. The minimum tick size is 0.05, which represents $50. VIX futures settle to a settlement reference index, under the ticker symbol VRO.
But futures aren’t for everyone. They involve leverage, and not all accounts allow the trading of futures. Plus, if you're looking to buy and hold volatility, the value of your investment might erode over time. See the slope in the chart above? If you were to buy a futures contract a few months out, and roll it to a deferred-month contract as it approaches expiration, absent changes to the term structure, you'd essentially be riding this curve downward. It's called "contango loss," and here’s a hypothetical example.
Suppose you bought a June contract, with about 2 ½ months until final settlement, around the price of 15.4, as shown in figure 1. Note that, at the time of your purchase, the May contract, with about 1 ½ months to go, is trading around 14.8. If nothing changed to the term structure over the next month, one month later your June contract would go from having 2 ½ months until final settlement, to having 1 ½ months to go and would be priced, theoretically anyway, around 14.8, where the 1 ½ month contract is priced in figure 1.
Volatility ETPs. If you're looking for a buy-and-hold strategy, and you either can't trade futures, or you don't wish to trade futures, there are a number of exchange-traded products (ETPs) that attempt to mirror the performance of the VIX. These products trade like a stock— they can be bought and sold on exchanges, and are generally available for most account types. But be forewarned— these are not stocks. And, though they typically attempt to track VIX performance, they don't always hit the mark. Since most of them use VIX futures, they're subject to the same contango loss as VIX futures, and also add in a number of administrative and transaction costs. Many professionals refer to these products as "watered-down vol exposure."
VIX Options. If you're looking for volatility flexibility and you have the appropriate level of options trading approval, you might consider VIX options. These are like standard equity options, with a few key differences. First, they are European-style options, which means they can only be exercised at expiration, as opposed to standards, which may be exercised on any business day up to and including expiration day. Plus, unlike standards, which are physically-settled into shares of the underlying stock, VIX options are cash-settled (at $100 times intrinsic value at expiration), with in-the-money options settling to the same settlement reference (ticker symbol VRO) as VIX futures. But perhaps the most important aspect of VIX options is that they're based not on the VIX itself, but rather on VIX futures.
If you've ever tuned in to our daily Swim LessonsSM you know this is our specialty—assessing market conditions and highlighting certain options strategies to potentially capitalize on market conditions. And most, if not all, of these strategies can be used in the trading of VIX options.
For example, are you anticipating a rise in market volatility? You might want to explore a bullish options strategy such as buying a call, or perhaps a long vertical call spread. In fact, a recent Swim Lessons article was devoted to assessing the risk-reward tradeoff of buying a single option versus a vertical spread. Or perhaps your objectives might be better served by a vertical credit spread—the selling of a near at-the-money option along with the purchase of a further out-of-the-money option of the same expiration date. On our Swim Lessons show, and in a recent article, we talked about selling vertical credit spreads.
Want more VIX options strategies? Join Swim LessonsSM on Wednesday April 5, at 10:30 AM CT as Kevin Hincks and I dive into “Trading Volatility With VIX Options”.
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