Now That You Know Volatility, Here’s How to Play It

0 | By Shah Gilani

Volatility comes in all shapes and sizes. It affects every stock, every market, and every asset class, everywhere around the world.

It can be your best friend or your worst enemy.

Either way, as Sun Tzu said, “Keep your friends close and your enemies closer.”

But whether or not volatility is your enemy today, tomorrow, or next week, you have to know how to manage volatility in your trading.

Here’s why you have to embrace volatility, how to see it coming, and how to trade it.

Volatility Comes in A Lot of Flavors

Volatility is every stock, every bond, every commodity, and every tradable instrument’s constant companion, so make it your best friend.

Like I mentioned earlier this week, there are a couple of types of volatility and they all mean different things.

Inherent volatility is how much and how quickly the value of any investment or market increases or decreases.

There are two types of inherent volatility: the first is historical volatility, which is measured by calculating the historical standard deviation of annualized returns over a given period of time.

The other is implied volatility, which is the expected volatility that buyers and sellers price into an asset at the last or average price at which it trades.

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Volatility can also be relative.

How volatile one stock is relative to another stock, where stocks can be substitutes for each other, matters. How volatile a stock is relative to the volatility of the market, measured as beta, matters. Changing volatilities of different asset classes in a portfolio, especially in risk-parity funds, matters.

Both inherent volatility and relative volatility matter.

Some investors shun volatility, while others, especially traders, seek volatility.

Volatility itself doesn’t discriminate. It just does what it does, until it completely changes, and then it usually reverts to its mean.

That’s the nature of volatility. Which is why it’s important to know the inherent volatility of investments you own and know how market volatility can affect your investments.

Knowing the inherent volatility of anything you own can be complicated or easy.

The complicated way to know how potentially volatile an asset is requires you to do the math.

The easy way is to look at how it trades over calm market periods and stressed periods. You can really see its highs and lows and the swings it makes when comparing the two periods. You can measure the swings relative to the average price over each period, and you’ll have a good general sense of how volatile that asset has been.

What’s important about knowing and being comfortable with how inherently volatile your investments are, is they are going to be impacted by larger market forces.

Understanding how they’re reacting and how what’s going on with market volatility can impact the inherent volatility and value of your holdings will help you make smarter buy, hold, or sell decisions.

I’ve been trading professionally for thirty-five years. And for me, the volatility of markets (and by markets I mean equity markets, bond markets, commodity markets, currency markets, derivatives markets, etc., especially when they are highly correlated) is more important than the inherent volatility of any single investment.

That’s because market volatility, because of its impact on sentiment, on psychology, on fear and greed, will, especially in stressed times, move most assets as if they’re tied together like climbers on a steep-faced mountain.

The mother of all market volatility measures these days is the VIX.

It’s the “vol” measure to watch because so many important equities, so many portfolios, so many asset managers, so many asset classes, are in, tied to, compared to, or correlated in some way to the S&P 500 index, which is what the VIX is a volatility measure of.

Last week I told you what’s really causing the wild market swings, and in Monday’s WSII, I talked to you about volatility basics. Some of these concepts are heavy, but these articles will make sure you’re not diving into the water without your floating device.

Tapping Into the “Fear Gauge”

If you understand the VIX and can trade it, not only will you be able to make money from it, you’ll better understand how everything in your portfolio trades. And the more you know about how things trade, the easier it becomes to make money trading them.

Here’s how easy it is to follow and trade the VIX.

First, always look at the VIX as a fear gauge and greed barometer.

When the VIX is consistently low, especially for long periods of time (like in 2017 when it hung below 10 for what seemed like all year), it’s saying that investors aren’t buying puts on the S&P 500 and they’re not afraid of volatility eroding their gains.

You should be buying and adding to your positions when the VIX is low and looks like its staying low.

As far as the VIX, if it’s low, one way to make money from it staying low is by “selling volatility.” There are two easy ways you can sell volatility, or “vol.”

You can sell vol, if you don’t expect volatility to rise much, by selling call options on the VIX. A call option on the VIX gives the person you sell it to the right to demand you “sell” them the VIX at whatever level (strike) call option you sold them. In reality, you’re not selling the VIX; you’re paying the difference between the strike price of the calls you sold and where the VIX is when you settle (close) the trade if it’s higher. If the VIX doesn’t rise, especially for long periods, you get to keep all the money you got selling calls that hopefully expire worthless.

Another way to sell vol is to buy an inverse VIX ETP (exchange-traded product). Investors who did that for the past few years made a ton of money as the VIX occasionally spiked, but for the most part remained low for long periods.

The problem, of course, is when the VIX spikes.

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You could end up losing big-time if you make good on the calls you sold. This can happen if you’re “short” calls (sale of a call option), or if the inverse VIX ETP you bought collapses, or if it has to be liquidated because it loses so much value when the VIX explodes.

Which is exactly what just happened. A lot of investors got burned selling vol by buying a couple of hot inverse VIX ETPs.

If the VIX is low and you want to sell vol to profit from volatility staying low, you can also sell put options on the VIX. If the VIX is already low, put options, which are a bet that it’ll go lower, won’t cost a lot, so you won’t get a lot for selling them. And you do have some risk because as low as something is, it can always go lower.

While it was a trendy and brilliant move to sell volatility (until it wasn’t), most investors buy the VIX – meaning they buy VIX futures, VIX calls, or VIX ETPs as a hedge against rising volatility or to speculate on rising volatility. They do this because, as we’ve seen over the past few weeks, markets don’t remain calm forever.

Buying VIX futures is expensive, and the margin is high, so I don’t recommend that for beginner investors. And buying VIX ETPs that are supposed to go up when the VIX goes higher isn’t something I’d ever recommend.

That’s because the way that those products are constructed. If they buy VIX futures, they end up losing money almost every time they “roll” the futures they own (by selling them as they near expiration and buying further dated expiration futures), because VIX futures are almost always in contango. That means the futures curve slopes upwards making further out futures more expensive. Those funds end up selling expiring futures they own at falling prices and buying more expensive futures to replace them. That’s a horrible recipe over time.

It’s Not About What You Make

Volatility can be darn complicated, so here’s what I suggest.

I like to buy VIX calls when I think volatility is going to increase. The trick is seeing the potential for volatility to rise before it starts rising and call option prices start rising rapidly.

One way I look for potential movement in the VIX is by watching the vix of the VIX, the VVIX.

Last year, especially over the past few months of last year and into January, VVIX was rising while the actual VIX was still stuck around 10. That was telling. And it proved right; the VIX broke out of its sideways volatility.

Another way to “see” ahead of the VIX rising is to look at big-name stocks in the S&P 500, especially the biggest-capitalization stocks, the top ten, (see sidebar), and see what’s been trending. If their volatility is increasing, if they are moving around (especially to the downside), then I’ll buy VIX calls.

However, making money on a rising VIX, especially a spiking VIX, is only half the battle.

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The mistake most investors make who buy volatility and see it spike is that they don’t take their profits. They see volatility rising, start profiting, think the VIX will keep going up, and usually end up missing out on most of the ride.

If you bet volatility is going to increase, and it does, take off half your profits when you have a 50% gain. I always do that. I then use a stop to sell the remainder of my position for at least a 25% gain, in case the VIX drops quickly, which it usually does. If that happens, I’ve got a blended gain of about 37.5%.

However, if the VIX keeps rising, I’ll ride the remainder of my position until my “gut” says I’ve made a good enough return and I’ll exit the position quickly.

With the VIX spiking, it’s not about what you make; it’s about what you keep.

Volatility tends to revert to its mean. That means after spiking, it settles down again.

Playing the VIX as a reversion to the mean trade is probably the most popular way to trade the VIX.

Buy volatility (the VIX) when it’s rising, and sell it when you’ve made you money on it rising. Short it (buy puts) to make money on it reverting to its mean.

Now that you know how to trade the VIX and how to manage volatility in your trading, you can apply what you know to all your other investments. They are all impacted by volatility in some way.

Enjoy your long weekend.



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