How to Profit From Volatility Through One Simple Investment
by Karim Rahemtulla, Options Expert
Tuesday, January 19, 2010: Issue #1178
When this market finally runs out of steam and corrects to the downside, Wall Street isn’t going to ring a bell to let you know.
The Wall Street Journal and Financial Times aren’t going to tell you.
And no… the folks at CNBC aren’t going to let you know either.
But while everyone else sits around and waits for volatility to kick higher and the market to decline again – promptly spinning into a panic – it pays to “buy insurance” now when nobody else is. And when it’s cheap, too.
Here’s a great way to do it. And what’s more… the investment I’m going to tell you about is trading around its lowest levels since its inception…
How the VIX Works… And the Drawbacks of Investing In it Directly
Am I predicting a market crash tomorrow? No.
Will the market correct at some point in the future? Yes.
And if you’ve read my recent columns on the VIX’s volatility, you’ll know that rather than just sitting back, you can profit from it. There are two ways that I play volatility…
- Options on the VIX.
- An ETN (exchange-traded note) called the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). This mimics the movements of the VIX.
The most important thing to note is that the VIX works in the opposite way to the broader market.
- When the VIX rises, it indicates that the market is usually going down – hence you’d buy call options.
- When the VIX falls, it indicates that the market is going to rise – so you’d buy puts.
You can trade VIX options in any account that allows you to trade options. The problem, however, is that they’re based on VIX futures. This means they don’t give you a way to play the current VIX prices.
In addition, the formula for calculating which option and expiration date to use isn’t simple. So you have to buy a couple of months ahead, select the call/put strike price nearest to the current VIX price, then “hope” that volatility moves sharply in your favor.
Not great. But the good news is that when the Volatility Index makes a sharp turn, we can take advantage with this investment instead…
The Best Way to Play Market Volatility and Protect Your Portfolio
To play the VIX on the long side – i.e. protect against a market correction – I recommend that you buy the iPath S&P 500 VIX Short-Term Futures ETN.
The note is an unsecured debt security, designed to track the S&P 500 VIX Short-Term Futures Index TR. This offers exposure to a daily long position on VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility curve.
Barclays has an overview of the VXX here.
Each time the VIX has traded in the teens, I’ve slowly built up my position in the VXX at increasingly lower prices. And at a current price under $30, it’s hovering just above the lowest price since its inception. That’s also 250% lower than its price when the market crashed in early 2009.
It might go even lower – and that would be fine with me because we can buy even more!
The downside is that unlike ETFs, ETNs have costs associated with them that are based on the movement of underlying shares, plus fees associated with buying and selling futures contracts. That’s in addition to the regular management fees that all funds have.
However, if you’re looking for a way to play stock market volatility and protect your portfolio from a correction, the VXX represents a solid investment. It’s a vehicle that I look to whenever I want to trade volatility.
Good investing,
Karim Rahemtulla
Investment U – Endnote: While the VIX measures overall market volatility, there’s also a way to gauge the volatility of individual stocks. It’s known as the beta.
Simply put, if the beta coefficient is 1.00, it means the stock’s volatility matches that of the broader market and the share price will generally move with it. A number under 1.00 signifies that the stock is less volatile than the market, while more than 1.00 indicates that the stock is more volatile than the general market.
You can find a stock’s beta number on its Yahoo! Finance “Key Statistics” page. For example, it’s no surprise to see that a financial stock like American Express (NYSE: AXP) has a beta of 2.26, meaning it’s significantly more volatile than the market (as you can see here). On the other hand, a more stable utilities firm like Southern Company (NYSE: SO) has a very low beta of just 0.34.
So whenever a stock is experiencing high volatility, understand that no matter which way it’s moving, you can profit from it. In other words, don’t just watch the moves happen… capitalize on the momentum.
Any investment contains risk. Please see our disclaimer.
10 Responses to “How to Profit From Volatility Through One Simple Investment”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Why would you build positions at lower prices in a chart that basically looks like a ski slope, straight down. Every time it pops up to it’s 50 day moving average it sells off again. Good luck with that stragety. Eventually we will get a good correction and you will get a bounce in the etn, but as someone said “the market can stay irrational longer than one can stay solvent”
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Shouldn’t these two comments be reversed or at least add “buy long term”?
~ When the VIX rises, it indicates that the market is usually going down – hence you’d buy call options.
~ When the VIX falls, it indicates that the market is going to rise – so you’d buy puts.
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I READ ANOTHER ARTICLE ABOUT THE VIX, AND IT SAID
VIX 10–15 SELL
VIX OVER 40 BUY
VIX OVER 50 BUY MORE
VIX 60–70 TAKE OUT A SECOND MTGE
SO IF THE VIX GOES BELOW 15 SHOULD I SELL MY STOCKS. I DO NOT DEAL IN OPTIONS
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Would we get the same protection as VXX offers by going long on SH ?
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The VIX isn’t causal – “When the VIX falls, it indicates that the market is going to rise – so you’d buy puts.” – The market rises, so the VIX falls (due to lower implied volatility and the skew of the SPX options).
Second, you are usually best off using front month VIX options – “you have to buy a couple of months ahead,”
And the VXX is based off the futures – just like the options – and it has serious issues of the futures premium and the futures roll.
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Thank you for your calming matter.I should know by now you have a eye on it. I sometimes need a little bit of common sense.
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~ When the VIX rises, it indicates that the market is usually going down – hence you’d buy call options.
~ When the VIX falls, it indicates that the market is going to rise – so you’d buy puts.
Am I missing something here? Or did you mean “sell calls” and “sell puts” respectively?
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Sara T., you are exactly on point. Karim has it wrong if you want to profit from options.
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SaraT,
When market goes down, VIX goes up and you should buy “calls” on VIX! Same way, when market goes up VIX is going down and so you would buy “puts”
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Gary,
Karim is right. See my reply to SaraT.
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