There are times when day trading volatility exchange-traded funds (ETFs) is very attractive, and times when volatility ETFs should be left alone. A volatility ETF typically moves inversely to major market indices, such as the S&P 500. When the S&P 500 is rising volatility ETFs will typically decline. When the S&P 500 is falling, volatility ETFs will rise. Just like the market indexes, trends also develop in the volatility ETFs. A strong uptrend in the S&P 500 means a downtrend in volatility ETFs, and vice versa. Day traders can exploit the big moves that occur in volatility ETFs at major market reversal points, as well as when the major indexes are in a strong decline.
ETFs vs. ETNs
Commonly referred to as volatility ETFs, there are also volatility ETNs. An ETF is an exchange-traded fund which holds underlying assets in that fund. An ETN is an exchange traded note, and does not hold any assets. ETNs don't have the tracking errors that ETFs may be prone to because ETNs only track an index. ETFs on the other hand, invest in assets which track an index. This extra step can create performance discrepancies between the ETF and the index it is supposed to represent.
ETFs and ETNs are both acceptable for day trading volatility, as long as the ETF or ETN being traded have lots of liquidity.
(Need a brush-up on indicators? See "The Four Most Important Indicators in Trend Trading.")
Choosing a Volatility ETF/ETN
There are a number of volatility ETFs to choose from, including inverse volatility ETFs. An inverse volatility ETF will move in the same direction as the major indexes (the opposite/inverse direction of traditional volatility ETF). When day trading, simple and high volume is usually the best choice. The iPath S&P 500 VIX Short Term Futures ETN (VXX) is the largest and most liquid in the volatility ETF/ETN universe.
The ETN sees average volume of at 20 million shares per day, but spikes to more than 70 million when the major indices--in this case the S&P 500--see a significant decline and traders pile into VXX pushing it higher (remember, it moves in the opposite direction of the S&P 500).
Best Times to Day Trade Volatility ETF/ETNs
VXX usually sees explosive moves when the S&P 500 declines. The moves in VXX typically far exceed the movement seen in the S&P 500. For example. A 5% drop in the S&P 500 may result in a 15% gain in VXX. Therefore, trading VXX provides more profit potential than simply short selling the S&P 500 SPDR ETF (SPY). Since VXX has a tendency to "overshoot" on declines in the S&P 500, when the S&P 500 rallies again VXX typically sells off in dramatic fashion.
Day traders have two ways to profit; buy VXX when the S&P 500 is declining, and then sell VXX following a price spike once the S&P 500 begins to rally higher again and VXX is falling.
Depending on the size of the trend in the S&P 500, favorable trading conditions in VXX can last for several days to several months. Figure 1 and 2 shows a short-term decline (and reversal) in the S&P 500 and the corresponding rally in VXX.
Figure 1. S&P 500 SPDR Decline and Rally
Figure 2. S&P 500 VIX (VXX) Corresponding Rally and Decline
Figure 2 shows how VXX has a tendency to overshoot; it rallied 38% based on a 5.7% decline in the S&P 500. It then fell 25% when the S&P 500 recovered the loss. Such are the times day traders will want to be trading in VXX. When the S&P 500 is in a very quiet uptrend with little downside movement, VXX will decline slowly and is not ideal for day trading. The big opportunities come during, and in the aftermath of, a several percentage point decline or more in the S&P 500.
Day Trading Volatility ETFs
Volatility ETFs, such as VXX, will quite often "lead" the S&P 500. When this occurs, it let's you know which side of the trade you want to be on. VXX can be used to foreshadow moves in the S&P 500, which can aid in day trading stocks even when there isn't substantial volatility in the S&P 500.
Figure 3 shows VXX (red line) continually moving aggressively lower as the S&P 500 SPDR (yellow line) grinds marginally higher. VXX breaks below its intraday low well before the S&P 500 SPDR breaks above its intraday high. The weakness in VXX helped confirm that there was underlying strength in the S&P 500 and that it was likely to retest or exceed its daily highs following the 11 a.m. pullback.
Figure 3. S&P 500 VIX (red line) Foreshadows Moves in S&P 500 SPDR (yellow line) - 2-Minute Chart Percentage Scale
The biggest intraday opportunities occur in VXX when there is a significant drop (and/or subsequent rally) in the S&P 500 as shown in figure 2 and 3. Regardless of whether these significant moves are present, the following entry and stop can be used to extract profit from the volatility ETN.
Based on figure 3, VXX is much weaker than the S&P 500 is strong. Near 11 AM the S&P 500 SPDR almost pulls back to its low of the day. but VXX stays well below its daily high. It is showing a lot of relative weakness which infers there is strength in the S&P 500 SPDR, despite the pullback in its price. This signals that there are opportunities on the short side in VXX.
Now that the weakness is established, look for a short entry. Wait for VXX to move higher and then pause on a one or two minute chart. When the price breaks below the pause/consolidation back in the trending direction, enter a short trade immediately. Place a stop loss order just above the high of the pullback.
Figure 4. Entries and Stop Loss When VXX is Weak
The same method applies when VXX is strong and S&P 500 is weak. VXX will be moving higher; wait for a pullback and a pause/consolidation. When the price breaks above the top of the consolidation at the bottom of the pullback (what we are assuming is the bottom) enter a long position. Place a stop just below the low of the pullback.
Manually exit trades if you notice the overall trend in the market shifting against you. If you are short, a higher swing low or higher swing high indicates a potential trend shift. If you are long, a lower swing low or lower swing high indicates a potential trend shift.
Alternatively, set a target which is a multiple of risk. If your risk on a trade is $0.15 per share, aim to take profit at two times your risk, or $0.30. For example, you go short at $31.37 and place a stop at $31.52 (this is the trade just after 11 AM in Figure 4). Your stop is $0.15 above your entry, therefore your target price is $0.30 below your entry (2:1 reward to risk ratio). This multiple is adjustable based on volatility. In very strong trends you may be able to make a profit that is three or four times as large as your risk.
If the volatility ETN isn't moving enough to easily produce gains which are twice as much as your risk, avoid trading it until volatility increases.
The Bottom Line
Volatility ETFs and ETNs usually have larger price swings than the S&P 500, making them ideal for day trading. The greatest opportunities in terms of percentage price moves come during and shortly after the S&P 500 has significant declines. A volatility ETN, such as the S&P 500 VIX (VXX) may even foreshadow what the S&P 500 is going to do. When VXX is relatively weak it shows the S&P 500 is likely to be strong. Either go short VXX or long the S&P 500 SPDR. When VXX is relatively strong it shows the S&P 500 is likely to be weak. Either go long VXX or short the S&P 500 SPDR.
When day trading a volatility ETF or ETN, only trade in the trending direction; wait for a pullback and a pause, and then enter in the trending direction when the price breaks out of the small consolidation. No method works all the time, which is why stop loss orders are used to limit risk and profits should be larger than losses. This way even if only half the trades are winners (profit target is reached), the strategy is still profitable.