Should You Trade Volatility?
Volatility is a relatively new asset class, coming on the scene in 2009.
Should you trade volatility? Traditional asset classes that we all know are stocks, bonds and commodities but volatility is a new and relatively little known asset class in comparison to the main standards.
Until recently, the VIX index was exclusively the domain of futures traders, but with the advent of VIX options and VIX ETNs and ETFs, the arena is now open to retail traders and investors.
The first volatility ETF was NYSEARCA:VXX which started trading in early 2009 and has remained extremely popular since then in spite of its problems that we earlier discussed.
NASDAQ:XIV came on the scene in late 2010 and many other volatility ETFs followed, long and short and leveraged and non-leveraged, using different term structures and enjoying different levels of success and acceptance.
As we've discussed, these don't directly track the VIX index but trade VIX futures contracts. For a retail investor, the main advantage to trading volatility is that you can do it within a conventional brokerage account, can go long or short, can use the ETFs within IRAs and 401ks and can take advantage of market moves that are always occurring as volatility ebbs and flows.
In today's markets, many analysts suggest that the Federal Reserve and other global central banks are actively working to boost stock prices to avoid recessions and get the global economy going again after the body blow it took in the 2008 financial crisis.
Many foreign central banks buy equity futures contracts to bolster stock prices and conspiracy theorists posit that foreign central banks are even doing the work of the Fed by buying stock futures in the U.S. market.
All of this action serves to suppress volatility and so we've seen historically low levels on the VIX index since the onset of the financial crisis in 2009.
Some investors use volatility products as hedges against losses in a primary stock portfolio while others take directional bets on volatility using the VIX ETNs and ETFs and options that are available. Others simply use volatility as another way of diversifying a portfolio, just as they would stocks, bonds or commodities.
The important considerations before trading volatility are the following:
--> Volatility products are not suitable for buy and hold style investing.
--> Long volatility products like VXX generally will suffer from time decay due to the effects of contango.
--> Inverse volatility products like XIV tend to benefit over time from contango as it provides a tailwind for these asset prices.
--> Risk management and a solid trading plan executed with discipline are vital if you are going to succeed in this arena.
--> Volatility products offer the opportunity for quick profits and losses.
--> Volatility products are not suitable for buy and hold investing as years of gains can be wiped out in a period of days or weeks during times of intense stock market volatility.
--> Volatility products can serve as a way to diversify your portfolio, hedge or make directional bets on a deep and liquid market.