Trading the Volatility and the VIX

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Is important to tell that isn't easy to trade the VIX: it's like an art. Experienced traders know that. Its special behavior forces you to take jealous control of your trade. That's why is best to make VIX trades only in the short term.

One of the concepts most used, and perhaps less understood, in the world of trading is volatility, that is, the degree of variation of the price of a stock in time, in both direction and speed. This variation is directly proportional to the risk. This makes a volatile stock more attractive for trade it (for short-term or swing traders in particular), but also riskier. Knowing how to use volatility in your favor for obtaining benefits is one of the arts of stock trading.

The critical importance of the Implied Volatility (IV)

Known and used by all traders, the options are the best financial instrument to make money by investing a fraction of the capital that we would use in stock as such. Long options have rights, while short (write) have obligations. So, options are basically buying or selling an asset at a specific price within a specified date, through the payment of a premium. That is, the options involve price and time, the two variables that define volatility, which make it, its main protagonist. An option premium (its current price) has two components: intrinsic and time value. 
- Intrinsic value is an option's inherent value. The only factor that influences an option's intrinsic value is the underlying stock's price versus the option's strike price. No other factor can influence an option's intrinsic value.
- Extrinsic value (time value) is the additional premium that is priced into an option, which represents the amount of time left until expiration. The price of time is influenced by various factors, such as the time until expiration, stock price, strike price, and mainly implied volatility.

So, let's see at a glance, the main characteristics of this incredible financial instrument, but from the concept of implied volatility, the basis of the option-pricing equation.

- Implied volatility affects directly price options and represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately.
- Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. So, options that have high levels of implied volatility will result in high-priced option premiums.
- Conversely, as the market's expectations decrease or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices

- So, a change in implied volatility for the worse can create losses, however, you are right about the stock's direction. That's why options are very difficult for novice traders: you need to know not only direction but speed.

- Each listed option has a unique sensitivity to implied volatility changes. For example, short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This is based on the fact that long-dated options have more time value priced into them, while short-dated options have less.

- Each strike price will also respond differently to implied volatility changes. Options with strike prices that are at the money ATM are most sensitive to implied volatility changes, while options that are further in the money ITM or out of the money OTM will be less sensitive to implied volatility changes.

- Implied volatility fluctuates the same way prices do. Implied volatility is expressed in percentage terms and is relative to the underlying stock and how volatile it is. So, each stock volatility should not be compared to another stock volatility range.

- Implied volatility moves in cycles: high-volatility periods are followed by low-volatility periods and vice versa. If you can see in its chart where the relative highs are, you might forecast a future drop in implied volatility or at least a reversion to the mean. Similar to its relative lows.

- In the process of selecting option strategies, expiration months, or strike prices, you should gauge the impact that implied volatility has on these trading decisions to make better choices. This knowledge can help you avoid buying overpriced options and avoid selling underpriced ones. In fact, to be profitable, you need to be aware of the amount of implied volatility (IV) that each option traded carries.

- The Greeks (Delta, Theta, Vega, and Gamma), are a set of risk measures, that help to value the sensitivity, or exposition, of the option to time decay, implied volatility, and price. Its use is ideal for analyzing more complex option spreads such as calendars, verticals, straddles, butterflies, or iron condors.

The VIX and its inverse relationship with the markets

The VIX, as a contrarian indicator, is an incredible weapon for technical traders to determine extreme conditions of bullish or bearishness of the market, using its inverse relationship: when the market is rallying, the VIX tends to drop; when the market is tanking the VIX tends to rise. Smart and serious investors use it to bet against the crowd when its greed (or fear) levels are high. And mainly, they use it as protection or hedge for their investments.

The VIX, also known as the 'fear gauge', measures the frequency and intensity of changes in the SP500 in the short-term (30 days), through the implied volatility IV of its at-the-money call and put options. A level below 20 generally indicates a bearish or complacent market, while reads above 30 are generally associated with a large amount of volatility, and mean that investor fears are taking place. 

Gauging a market sell-off with the VIX

Investors and smart traders, who know that VIX-linked products are short-term trading instruments, usually buy volatility on market sell-offs using $VXX, the ETN that replicates the VIX behavior, as with all indices, you can’t buy it directly.

When the VIX is extremely high (above its mean value plus two standard-deviation, that's above 36, with the crowd panicking and closing positions) they are more inclined to buy VXX puts or $SPY calls as a speculative position, without too much concern for the prices they have to pay.  On the other side, with a market with low volatility, and as long implied volatility is low, seems a good opportunity to buy VXX calls or SPY puts at reasonable prices as a protection for our portfolio. 

For a market crash, when VIX exceeds its mean value plus three standard-deviation, that's above 46, the idea is the same: speculate on high VIX or protect on low VIX.

How to play a ranging VIX

You don't need an extreme market situation like the one above, to play with the VIX. Unlike any stock, with the VIX I have defined my framework where I analyze its price action: daily chart and in the short-term. And I get better and more clear results with just two studies: the Bohlinger Bands and the Daily Moving Average 200.  

In any market behavior with a ranging VIX, as accustomed most of the time, the BB works even better as the VIX price travel nicely between its two "rubber bands": overbought and oversold. And the DMA200 is great as a dynamic support-resistance level, even more taking into account that is probably the most used and reliable trend indicator, hugely used by traders and investors.

In the chart above, first, verify the inverse correlation between the VIX and the SP500. It happens all the time, like a mirror image. Second, as the VIX value raises or falls, check how it bounces off the upper or lower band of the Bohlinger Bands. Therefore, the "logical" play, after verifying price action, is going long in VXX when the VIX falls to the lower band of the BB. At that moment the market is at a peak and began a pullback, as you see in the chart. The same idea, but contrary, is used for the upper band of the BB: go short in VXX, and verify the SP500 began to rebound.

Now, check the dashed-line DMA200: since August acts as a strong resistance (yellow circles) for the VIX. Finally, after three attempts, in early October the VIX breached its DMA200, and the SP500 now reversed dramatically. These breakouts, if confirmed, are very attractive entry points for a disciplined trader. Notice that in early November and December, the DMA200 become strong support, with two new failed attempts to crossover it.

Strategy using only the VIX spikes

More than a strategy, it's a tip when trading the VIX. In its daily chart notice the clear difference between its relative tops and bottoms: tops are spikes, like an inverted V, while bottoms are more rounded.

- In the tops, this is because fear is the predominant feeling, which very fast becomes panic. This rapid rise is usually followed by a bearish candle when smart investors decide to start trading.

- On the other hand, at the bottom of the VIX chart, the market is more complacent, greed is in charge of the traders' feelings and so the SP500 costs more to fall, that's why bottoms are slower and full of false signals.

The diligent trader has already grasped the idea of this strategy: trade in the spikes of the VIX daily chart, operating shorts or puts. To find an acceptable entry point, the Bohlinger Bands are useful: waiting for the moment when the bullish candle leaves the upper band with some slack. Then expect a next bearish engulfing candle that wraps it completely (or almost) the previous bullish. The opening of the next candle is my entry point. Everything is very simple. However, there are a couple of undefined points in this strategy. One of them is not being clear about the exit. Perhaps the best idea is to set in advance a risk-reward, like the popular 1: 3 used by many traders, to determine the exit.

The "VIX spike strategy" works best in its daily chart. Every year happens, few times but powerful. In this chart, taken from 2015, we noticed two big spikes overcoming the upper band of the Bohlinger Bands (mid-October and mid-December, in the yellow circle), both followed by an engulfing candle that generates the quick and important reverse.

Two more spikes happen in January and February 2016 (also in a yellow circle) but in both cases, its price didn't overcome the BB, so its reverse isn't as powerful as the 2015 spikes. Finally, in the pink circles, we had two spikes that haven't an engulfing candle enveloping them, so the reverse seems very unclear.

The other complicated point of this strategy is the location of the stop loss. The usual is that the VIX continues its fall the following days and is difficult it returns above the engulfing candle, however, it can happen. A double top would be formed, the most reliable figure in the technical analysis according to Alexander Elder, where we could confidently sell the VIX. The best plan is to trial daily the stop loss to a safe level.

Good trading,

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