Volatility exchange traded funds (ETFs) can sometimes offer interesting day trading opportunities, but there are other times when volatility ETFs should be left alone. A volatility ETF will typically move in the opposite direction to major stock market indexes, such as the S&P 500 Index or the Dow Jones Industrial Average. For example, when the S&P 500 is rising, volatility ETFs will typically decline. On the other hand, when the S&P 500 is falling, volatility ETFs will usually rise.
- Day trading volatility exchange traded funds (ETFs) can be attractive at times, but there are other times when volatility ETFs should be left alone.
- An ETF is an exchange traded fund, which holds underlying assets in that fund.
- An ETN is an exchange traded note, does not hold any assets, and is structured as a debt security..
- Volatility ETNs, such as VXX, will quite often "lead" the S&P 500, and when this occurs, the signal lets you know whether to be long or short.
- VXX usually sees explosive moves when the S&P 500 declines, and the moves in VXX typically far exceed the movement in the S&P 500.
Just like stock market indexes, trends also develop in the volatility exchange traded funds. A strong uptrend in the S&P 500 usually 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, volatility exchange traded notes (ETNs) also exist. An ETF is a fund that trades on the stock exchanges and holds underlying assets in that fund. An ETN is an exchange-traded note, which also trades on the exchanges, but is structured as a debt security 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, and the value of those assets can deviate from the index itself. When divergences happen, it can create performance discrepancies between the performance of the ETF and the index it is supposed to represent.
Nevertheless, ETFs and ETNs are both acceptable for day trading volatility, as long as the ETF or ETN being traded has a lot of liquidity, which is measured by trading volume or the number of shares traded each day.
Choosing a Volatility ETF/ETN
There are several volatility exchange-traded funds to choose from, including inverse volatility ETFs. An inverse volatility ETF will generally move in the same direction as the major stock market indexes (the opposite/inverse direction of traditional volatility ETFs). When day trading, a simple ETF/ETN with 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.
Average daily share volume of iPath S&P 500 VIX Short-Term Futures ETN (over 10 days ended 3/20/2020).
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 shorting 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.
- Short 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. The chart below shows a short-term decline and reversal in the S&P 500 and the corresponding rally and selloff in VXX.
The charts confirm that VXX has a tendency to overshoot; the ETN rallied 105% based on an 11.84% decline in the S&P 500. It then fell 31.6% when the S&P 500 bounced 10% off the low. Such are the times day traders will want to be trading VXX.
When the S&P 500 is in a 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 or ETNs, such as VXX, will quite often "lead" the S&P 500 Index. When this occurs, it lets you know which side of the trade you want to be on (long or short). For example, the charts below provided several clues that the S&P 500 would move higher.
VXX (top chart) was weaker in the morning, moving lower overall even when the S&P 500 (bottom chart) made a lower low. Then, VXX broke its major support level just after Noon ET, indicating that the S&P 500 could eventually break through its resistance level. It did about half an hour later.
VXX won't always lead the S&P 500. Sometimes the S&P 500 will lead, which can also provide us with clues for day trading VXX. The biggest intraday opportunities occur in VXX when there is a significant drop (and/or subsequent rally) in the S&P 500. During such times, the following entry and stop can be used to extract profit from the volatility ETN.
The charts below provide an example. At 10:43 a.m. ET, the S&P 500 (bottom chart) has just made a lower low and then starts to rally. At that same time, VXX (top chart) is well below its high and is forming a sideways channel (highlighted by the rectangle on the chart). The S&P 500 continues to rally. A day trader should now be piecing together that VXX is weak (lower low) and that, if the S&P 500 is rallying, then VXX is likely to start dropping soon.
Wait for a trade trigger. This is an event that actually tells you the price is starting to drop. In this case, VXX is moving in a channel or small consolidation above $33.38. If the price drops below $33.38, then the channel is broken, and given the other pieces of evidence, a short trade in VXX can be taken.
Placing a stop-loss order $0.02 above the most recent high (which occurred just prior to entry) makes sense to protect the short position. If going long, place a stop-loss order $0.02 below the most recent low that occurred just prior to entry.
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 that is a multiple of risk. If your risk on a trade is $0.14 per share, aim to take profit at two times your risk, or $0.28. For example, the short trade above was initiated at $33.37 with a stop-loss order at $33.51. The distance between the entry and stop loss is $0.14. Therefore, aim to make at least $0.28 on the trade (two times risk) by placing the target $0.28 below entry at $33.09. This two-times-risk multiple is adjustable based on volatility. In very strong trends, profits may even equal three or four times the amount at risk.
If the volatility ETN isn't moving enough to easily produce gains, which are twice the amount that you risk, avoid trading until volatility increases.
The same method applies when VXX is strong and the S&P 500 is weak. VXX will be moving higher, wait for a pullback and a pause/consolidation. Then, when the price breaks above the top of the consolidation, enter a long position. Place a stop-loss order just below the low of the pullback.
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 iPath S&P 500 VIX Short-Term Futures ETN, may even foreshadow what the S&P 500 is going to do next.
No trading approach or method works every time, however, which is why stop-loss orders are used to limit risk. 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. If you can't reasonably expect to make a profit at least two times your risk, based on that day's volatility, then don't trade this strategy.