Successful Trading With Volatility ETFs

Volatility is the rough price fluctuations seen in stocks, exchange-traded funds (ETFs), and other securities. While many investors ignore volatility, savvy traders have long used smart strategies to profit from volatility swings. 

This guide will explain volatility’s complexity, compare exchange-traded funds and notes, and provide proven trading plans for successfully riding volatility’s ups and downs for gains. 

What is Volatility?

Volatility refers to how the price of a security moves up and down. High-volatility assets experience large price swings, while low-volatility assets have more modest fluctuations. 

It also changes over time for an asset based on market conditions. During periods of economic uncertainty, volatility tends to rise across asset classes.

Some measures of volatility include:

• Historical Volatility: How much have prices fluctuated over a set historical period? This provides insight into an asset’s typical volatility range.
• Implied Volatility: The market’s expectations for volatility over the life of an option contract. Implied volatility changes as traders buy and sell options.
• Volatility Indexes: Indexes that track implied volatility, such as the VIX, which tracks S&P 500 volatility.

Volatility creates risks but also opportunities. When volatility rises, there is greater potential for large price movements in either direction. Traders utilize various strategies to profit from volatility - or hedge against volatility risk.

Volatility and ETFs

Exchange-traded funds (ETFs) provide a straightforward way to trade volatility. Some ETFs track volatility indexes or volatility futures contracts.

The most popular volatility ETF is the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX). It aims to mimic the performance of the S&P 500 VIX Short-Term Futures Index, which reflects implied volatility for near-term S&P 500 Index options.

Other examples of volatility ETFs include:

• ProShares VIX Short-Term Futures ETF (VIXY)
• iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ)
• VelocityShares Daily Long VIX Short-Term ETN (VIIX)
• ProShares VIX Mid-Term Futures ETF (VIXM)
• iPath Series B S&P 500 VIX Long-Term Futures ETN (VXXB)

These provide exposure to different parts of the volatility futures curve - from short-term to mid-term to long-term expectations for volatility. Traders choose other ETFs based on their volatility outlook.

Volatility Exchange-Traded Notes (ETNs) vs ETFs

Product Structure

ETFs own underlying assets. Volatility ETFs hold futures contracts, options, swaps, or other securities linked to volatility indexes. They replicate performance by directly owning volatility assets. 

ETNs are unsecured debt. Volatility ETNs are senior debt notes issued by banks. Their returns come from the issuer’s credit. ETNs do not hold volatility assets.

Counterparty Risk

ETFs have no counterparty risk. Since they directly own assets, volatility ETFs do not rely on a third party to pay out returns. The ETF structure eliminates counterparty risk. 

ETNs have credit risk. ETN returns depend on the financial strength of the issuing institution. If the issuer goes bankrupt, ETN holders risk losing some or all of their investment.

Tracking Error

ETFs can have tracking errors. Volatility ETFs aim to track benchmark volatility indexes closely, but some tracking errors can occur. Factors like fees, holdings mismatches, and futures rolling costs can cause ETF performance to deviate slightly from the index. 

ETNs won’t deviate from the index: Because ETNs are debt securities, their returns are contractually tied to the benchmark. Volatility ETNs will not diverge from the index due to tracking errors.

You might also like to read: ETFs vs Mutual Funds

4 Strategies for Trading Volatility

Now that we’ve covered how to access volatility trading through ETFs let’s look at some of its effective strategies.

1. Ride Short-Term Spikes

When volatility spikes, VIX products often see huge short-term gains. Traders can capitalize by getting long exposure for a short period around events that may stoke volatility. 

Examples include Federal Reserve meetings, major economic data releases, elections, and geopolitical turmoil. Be ready to take profits quickly as volatility spikes often fade.

2. Fade the Gap When Volatility Spikes

This contrarian strategy involves looking for opportunities where the VIX spikes but actual (realized) volatility remains low. When this happens, VIX products can experience sharp mean reversion. 

Traders take short positions when the disconnect between actual and expected volatility appears excessive.

3. Compare Relative Value Across the Volatility Curve

You can identify parts of the volatility curve that may be overextended by analyzing ETFs linked to short, medium, and long-term volatility futures. 

For example, short-term volatility products may be primed for a reversal if near-term volatility expectations surge but longer-term expectations stay stable. Take advantage of using ETFs to trade relative value across the volatility curve.

4. Use Volatility ETFs for Hedging

Volatility ETFs can help hedge portfolios against market declines. Because volatility tends to rise when stocks fall, long volatility exposure can offset losses from an equity portfolio. 

Holding a basket of volatility ETFs that target different parts of the volatility curve provides broad protection. Manage position size based on your portfolio’s sensitivity to volatility.

Volatility Trading Risks & Drawdowns

While volatility trading offers lucrative potential, it comes with significant risks:

• Volatility Dragging - Extended low volatility periods can cause long VIX holdings to slowly decay over time.
• Contango Headwinds - Due to contango in the volatility futures curve, longer-dated futures tend to trade higher than near-term futures. This dynamic can negatively impact volatility ETFs.
• Unexpected Volatility Declines - In periods of strong trending markets, actual volatility can remain low even as stocks rise. This can hurt long volatility plays.
• Leverage Erosion - Volatility ETFs using leverage can see leveraged losses quickly erase gains from volatility spikes.
• Volatility Mean Reversion - Volatility spikes often partially or fully revert down. This makes timing entries and exits crucial.
• Correlation Changes - At extreme market stress, equity and volatility correlations can break down.

Due to these risks, volatility ETFs commonly experience severe and prolonged drawdowns. Manage position size carefully and utilize prudent risk management. Volatility trading strategies require constant vigilance.

Find insights in this article: 7 ETF Trading Strategies

Closing Thoughts

Traders should utilize ETFs to capitalize on short-term volatility movements, fade gaps between actual and expected volatility, trade relative value across the volatility curve, and hedge portfolios. 

Be cautious of volatility drag, contango effects, unexpected volatility declines, leverage erosion, and mean reversion. Manage risk prudently. 

Traders who study historical volatility patterns and control position sizing, time entries, and exits judiciously can benefit and successfully win the volatile market.

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“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”