How To Use Volatility ETNs (VXX & VXZ) To Protect Your Stock Portfolios

When asked what he thought of the stock market, JP Morgan quipped: ‘It will fluctuate’. Indeed. Markets go up and down – and when prices are down, investor fear increase and volatility spikes. This is simply because of higher market uncertainty. Given volatility’s inverse behaviour to prices, volatility indices are usually known as the ‘fear gauges’.

One of the most established volatility indices is the VIX index. This index is based on the options on the S&P 500 Index (SPX), the most-watched US equity index. SPX is a very broad measure of the US stock market and it tracks the cream de la cream of US listed firms.

But you can not trade an index directly.  Neither can you trade volatility directly like you trade stocks. To do that, you need derivatives – like futures and options – to make a bet on the direction of the index. Thus VIX futures (based on the VIX index) were created at around 2004 to facilitate trading and hedging of volatility.

Sensing a growing demand for retail volatility products, astute finance firms like Barclays pushed this concept further by creating a series of Exchange Traded Notes (ETN). These notes were based on VIX futures (nearest two).

What brokers offer VXX and VZN trading and volatility indices?

You can compare the best CFD brokers for trading VXX here or take a look at the individual reviews for brokers below:

What is Volatility Trading?

In 2009, Barclays created two of the earliest volatility ETNs – VXX and VXZ (its sister fund). These ETNs were made available for volatility trading in the United States just like any other stocks (prospective here).* They can be sold, bought, or sold short whenever the market is open for trading, and that includes both pre-market and after-market timeframes. The current market cap of VXX is around $800 million. The average daily volume consists of 40 million shares, and its liquidity and spread status is very good. The bid–ask spreads are just a penny.

For example, the chart below shows the typical spread from IG index. In other words, moving in and out of volatility products are not overly expensive here in the UK.

To trade volatility ETNs successfully, however, you need to remember two things:

  1. Volatility ETNs are not meant for long-term holdings
  2. Volatility ETNs are high risk and prices can swing wildly over a short period of time

You can judge this from the price movements of VXX in 2018. Throughout the year, prices went from $28 to $50 twice. Daily 5-10% moves occur regularly; overnight price gaps further amplify this swings. So, how exactly do you use VXX to hedge against your long-only portfolio?

The general rule of thumb is to buy a small amount when the product is down for some time. Why? This is because markets tend to go up slowly and go down quickly, especially as we are on a bull cycle.

For example, VXX can roll lower continuously for six months and then, all of a sudden, surge. This price behaviour is typical (red circle, below). Accordingly, when VXX is down, buy some and hold for a few weeks before selling out.  Of course, you may very well sell at a loss, but try to think of this as as the cost of protection for your share portfolio. The trick is to time your entry because VXX can move very fast.

Other entry signals for VXX include: 1) A bullish crossover of VXX against some medium-term moving average such as the 50 or 100-day moving average, or 2) Corrective setbacks after hitting multi-week highs, ie, around $32.

In all these cases, the advice is to limit the holding period because volatility ETNs can depreciate over time.  Of course, having stop-losses on these positions are critical. Also, if you had timed VXX’s rally correctly, use trailing stops to protect your profits.

*http://www.ipathetn.com/US/16/en/documentation.app?instrumentId=259118&documentId=6204338

 

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