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Tales of a Technician: Behold, the Vexation of Volatility Catching

February 8, 2017

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Tales of a Technician: Behold, the Vexation of Volatility Catching

Perhaps no group of traders is more frustrated right now than those attempting to bottom fish the volatility markets. The interminable wait for a rise in volatility is bringing angst to those who only know how to thrive in hyperactive markets. Not to mention the well-meaning traders who have been trying their hand at profiting on the long side in VXX and UVXY.

Poor souls.

The pair of volatility ETNs should carry the tagline “the widowmaker” just to make sure the denizens of the Street buying them are acutely aware of what awaits. To ensure today’s missive isn’t too cryptic let me bring you up to speed on these volatility products.

First, the go-to Index for all things volatility is the CBOE Volatility Index. Because of its ticker symbol, we affectionately refer to it as “the VIX.”

Second, the VIX is an untradable statistic that can’t be bought or sold. It tends to oscillate up and down over time with low readings eventually giving way to high readings and vice versa.

Third, even though you can’t trade the VIX Index directly, there are futures contracts listed on it that allow sophisticated traders to speculate on its movement.

Fourth, there are exchange-traded notes (ETNs) that are designed to track VIX futures.

Fifth, VXX is the most popular volatility ETN and aims to model a hypothetical 30-day VIX futures contract.

Sixth, UVXY is VXX on steroids. It’s a leveraged ETN designed to move 2x the daily movement of VXX.

Seventh, the structure of both products is complex. In my not-so-humble opinion, you should steer clear of these vehicles until you understand all the vagaries of implied volatility, including the relationship between the VIX Index and VIX futures, how to analyze the term structure of VIX futures, and concepts like contango and backwardation and their impact on the behavior of VXX and UVXY.

Until you understand these concepts, good luck trading the widowmakers. You’re going to need it. It’s hard enough making money trading products you know. Let alone dabbling with overly complicated derivatives that a rocket scientist may have trouble understanding.

Now, to the meat and potatoes of what I really wanted to talk about today. Some people like to buy VXX because it goes up in the short run when the VIX spikes. And since the VIX spikes when the stock market drops, these funds are often viewed as portfolio hedges. They act as diversifiers that make money when all your beloved stocks are being taken behind the woodshed.

In an ideal world, you would buy VXX right before a market crash, then ride it to the moon and exit gracefully to play with your profits in the low gravity. In the real world, things are messier. Nailing a bottom in VXX is insanely difficult. If you’re buying it for portfolio protection you’re probably going to be early. And the fund doesn’t sit still until a VIX spike materializes, no. Like a slow leaking tire, it loses a bit of value day after day after day. This makes it a pain to hold long enough until the much-anticipated market selloff materializes.

So what do I suggest for traders seeking something that rises in value when the market falls? Frankly, I can think of a million things I’d prefer over a long VXX position. Like bear calls spreads or put calendars. At least those don’t get their heads chopped off when the market meanders.

If you’re intent on playing VXX and the like to the long side, then you best make sure you’re position sizing correctly. And learn how to hedge it if it goes against you. And, maybe, figure out a timing system that gets you in only when VXX starts trending higher.

If you made it this far then a hearty boo-yah to you. Lady Luck just told me she’s going to hook you up one of these days.

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2 Replies to “Tales of a Technician: Behold, the Vexation of Volatility Catching”

  1. Mak Mak says:

    thanks Tyler. Great article!
    I must’ve missed the “widow-maker” cue when i bought UVXY many moons and 2 reverse splits ago x'( although I have been cashflowing it since, the ROI on calls doesnt match the LOI. recently exited my position @ for a L seeking more fertile land, but a lesson that has tatooed my membrane.

  2. Avatar ChristopherRogers says:

    Bought VXX last year and it made me pay. I’m glad I took the loss when I did otherwise I would be really crying right now. A lesson learned the hard way that I won’t soon forget.

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