Shorting the VIX: How to Fade the Fear · Wealth Builders Community

Shorting the VIX: How to Fade the Fear

Savvy traders are always on the lookout for opportunities to profit from various market conditions. One of these strategies involves shorting the VIX(Volatility Index) a measure of market volatility and also referred to as the "fear gauge". When the VIX has a large spike this move can create an opportunity to profit off of irrational fear in the market. In this reading, we will explore a powerful strategy to short the VIX and two instruments SVXY and SVIX to help you achieve it. When you finish this reading you will gain a new strategy to add to your playbook that I like to call "Fading the Fear".

Disclaimer:

The information provided in this article is for informational purposes only and does not constitute financial advice, investment advice, trading advice, or any other type of advice. The content is based on personal opinions, research, and market analysis and is not tailored to the financial situation or investment goals of any specific individual.

Investing in financial markets involves risk, including the potential loss of principal. The strategies discussed in this article, including shorting the VIX using SVIX and SVXY, are speculative and may not be suitable for all investors. Before making any investment decisions, it is important to conduct your own research, consider your financial situation, and consult with a licensed financial advisor or professional(such as our good friend Nathan Winklepleck, CFA).

The author and publisher of this article are not responsible for any losses or damages that may result from the use of the information contained herein. All investments carry risk, and past performance is not indicative of future results.

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Before diving into the strategy and these ETFs it is important to understand the VIX. Officially known as the CBOE Volatility Index, this index measures the market's expectation of future volatility over the next 30 days based on options prices for the S&P500 index(SPX). High levels on the VIX indicate the market expects significant fluctuations and the sentiment is fear and uncertainty. Low levels indicate a calmer market and sentiment is positive. When we short the VIX we are betting that the market will be calmer/lower volatility, revert to the mean, or believe the fear is irrational.

Two ETFs we can use to profit from falling volatility are SVXY and SVIX. Both funds use first and second-month futures contracts with an average weighted maturity of one month. The funds should be traded/held in the short term(think 1 day to a few weeks). Long-term holding presents extra risk and can result in large losses if volatility spikes or if volatility remains elevated for a long time and both funds have large expense ratios. Both of these funds issue K-1 tax forms which may create additional expenses when filing taxes so be sure to check with your CPA.

SVIX-(-1x Short VIX Futures ETF): SVIX is designed to provide the inverse (-1x) of the daily performance of the S&P 500 VIX Short-Term Futures Index.

SVXY-(ProShares Short VIX Short-Term Futures ETF): SVXY seeks to achieve results corresponding to one-half the inverse (-0.5x) of the daily performance of the S&P 500 VIX Short-Term Futures Index. More risk-adverse traders or traders with larger stop losses can use this ETF over SVIX to lower exposure if risk management is an issue with SVIX.

To execute this strategy we use shares. You do not want to purchase options in high volatility. You could sell puts or other bullish credit strategies. However, for simplicity of trade management, it is easier to execute the strategy with shares. See the options paragraph on the bottom of the reading for a quick explanation of volatility for options.

In the history of the VIX, volatility hasn't remained elevated for very long above 30 and even more so for values past 30. These extreme volatility points present an opportunity to bet on the mean reverting properties of the VIX. We can analyze this with the recent volatility spike of August 5th and how a trader can potentially capitalize on volatility unwinding with SVIX.

SVIX had a high of $27.80 and a low of $17.51 on the 5th. The VIX had a low of 23.39 and a high of 65.73 on the 5th as well. There are many potential entry strategies whether you DCA(Dollar Cost Average) on the candle break and close above 30, wait for a long upper wick, or wait for a large bearish unwinding candle after the VIX tops out. For simplicity let's say you DCA on 5th after the candle closes above 30 on the VIX and have a cost average of $22.65 the middle price of high and low for the day. For a simple stop loss, we can use the day's low for SVIX which was $17.51.

Do not take excessive risk or use funds you can't afford to lose!

For trade size, you can use the general rule of 0.5-2% account value or you may also Kelly criterion if you know your win rate and risk/reward ratio for trading and want to maximize your gains mathematically.

A 1:1 risk reward for this trade would have a take profit at $27.79 with a gain or loss of $5.14 per share or about 22.7%. Trade would have closed on the 12th of August or for about 7 days.

A 1:1.5 risk reward for this trade would have a take profit at $30.36 with a gain or loss of $7.71 per share or about 34%. Trade would have closed on the 14th of August or for about 9 days.

A 1:2 risk reward for this trade would have a take profit at $32.93 with a gain or loss of $10.28 per share or about 45.4%. Trade would still be on at the time of writing. This is why I prefer trimming instead of fixed trades.

Trimming positions or DCAing out at fixed percentages(5%,10%,20% ect.), fixed prices, and/or use trailing stops like a moving average or ATR value is another way to approach profit-taking for trades. This requires more discipline than a systematic approach. However, it can be a way to potentially extract a little extra return from the trade if the trade continues to move in your favor or tactically close your position if the trade is no longer working in your favor and keep from losing all gains made so far.

It's unlikely for the average trader with good risk management to build a whole trading career off this strategy due to VIX not going above 30 super often as of this writing. For the average trader, it is a good side strategy to have in times of high volatility and potentially offsets unrealized/realized losses for investors holding stocks or ETFs during high volatility or market uncertainty.

A quick word about volatility for options. When volatility is high, you want to use credit strategies (receive premium/sell options), and when volatility is low use debit strategies (pay premium/buy options). It is possible to lose money buying options in high volatility if volatility decreases the option's value decreases even if you're right on the direction. It is also possible to lose money selling options in low volatility if volatility increases as the value of the sold option increases higher than your sold price. The effect of volatility on price can be seen in an option's Vega value which is the amount an option's price changes in response to a 1% change in implied volatility(IV). The key is to make sure you're on the right side of volatility and option greeks in general when trading options contracts.

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