Volatility moves markets as reliably as price or volume, expanding and contracting over time in reaction to greed and fear. Periods of high volatility reflect high risk, high reward environments, in which perfect timing can book impressive profits while getting it wrong can trigger severe losses. Many market players avoid price prediction entirely during stressful periods, instead placing bets on the direction of volatility through VIX futures or specialized equity funds that react to those contracts. While profiting from these instruments requires sophisticated skills, the payoff is worth the effort, especially when volatility is trending strongly, higher or lower.
Created in 1993, the CBOE Market Volatility Index (VIX) provides real-time snapshots of greed and fear levels, as well as expectations for volatility in the next 30 sessions. It provides the basis for futures pricing, as well as strategies that market timers can use to time entries and exits into volatility-based equity funds. Introduced after the 2008 economic collapse, these complex instruments have grown enormously popular for both hedging and directional plays.
Buying and selling of these securities have generated a leadership effect on the VIX indicator and VIX futures contract in recent years due to their enormous volume. You can see this happen when funds break out, break down and reverse ahead of the underlying indicator. This effect is most prevalent in highly volatile market conditions.
While VIX futures offer the purest exposure to volatility’s ups and downs, volatility funds attract far more volume because they’re easily accessed through equity accounts. Rather than exchange-traded funds (ETFs), many of these instruments are Equity Traded Products (ETPs) that utilize complex calculations layering multiple months of VIX futures into short- and mid-term expectations.
Volatility funds and average volume (3m)
(Data: February 2018 according to Yahoo Finance)
Inverse/leveraged volatility funds and average volume
(Data: February 2018 according to Yahoo Finance)
Real-time pricing of funds decays through contango, which reflects timing variations between futures contract and spot prices. These calculations can squeeze profits in volatile markets, causing the security to sharply underperform the underlying indicator. As a result, they work best in short-term strategies that utilize aggressive exit techniques, long-term strategies and hedges, and in combination with VIX futures and protective options plays.
Volatility fund strategies require a two-step approach that examines VIX as well as price action on the targeted fund. An understanding of VIX technical analysis can mitigate the profit-dampening effect of contango by identifying levels and turning points where funds will lose trend momentum. It works because longer-dated futures contracts used to calculate pricing are less sensitive to short-term VIX movement, exerting a greater effect when trend momentum wanes.
The VIX chart generates vertical spikes that reflect periods of high stress, induced by economic, political or environmental catalysts. It’s best to watch absolute levels when trying to interpret these jagged patterns, looking for reversals around big round numbers, like 20, 30 or 40 and near prior peaks. Also pay attention to interactions between the indicator and 50- and 200-day EMAs, with those levels acting as support or resistance.
Keep a real-time VIX on your screens when considering entries into volatility funds. Compare the trend with price action on popular index futures contracts, including the SP-500 and Nasdaq-100. Convergence and divergence relationships (see Read Market Trends With Convergence-Divergence Analysis) between these instruments generates observations that assist in market timing and risk management:
- Rising VIX + rising SP-500 and Nasdaq-100 index futures = bearish divergence that predicts shrinking risk appetite and high risk for a downside reversal.
- Rising VIX + falling SP-500 and Nasdaq-100 index futures = bearish convergence that raises the odds for a downside trend day.
- Falling VIX + falling SP-500 and Nasdaq-100 index futures = bullish divergence that predicts growing risk appetite and high potential for an upside reversal.
- Falling VIX + rising SP-500 and Nasdaq-100 index futures = bullish convergence that raises odds for an upside trend day.
- Divergent action between SP-500 and Nasdaq-100 index futures lowers predictive reliability, often yielding whipsaws, confusion and rangebound conditions.
Measure volatility trends with long- and short-term VIX charts, looking for sympathetic fund plays. Rising VIX tends to increase correlation between equity indices and underlying components, making long-side fund exposure more attractive. Falling VIX reverses this equation, supporting short-side entries that require profit-taking while VIX returns to longer-term averages.
The Bottom Line
Volatility funds offer exposure to high "greed and fear" levels while avoiding predictions on price direction. Complex fund construction makes them best suited to short-term trading strategies in volatile conditions and long-term short-side strategies in benign and quiet conditions, including bull market environments.