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Outside the Box
Sept. 9, 2010, 9:20 a.m. EDT · Recommend (6) · Post:
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Best Buy gets Kindle -- not a minute too soon
By Adam Warner
NEW YORK (MarketWatch) -- The Chicago Board Options Exchange Market Volatility Index, commonly known as the VIX by its ticker or "the fear index" among traders, is a useful tool. Not only is it one of the most common measures of volatility, it can also be a source of profits for those inclined to bet on future VIX movement.
But here's the catch: While it can be very profitable to trade the VIX /quotes/comstock/20m!i:vix (VIX 22.20, -1.05, -4.52%) and related derivatives or use them as a hedge, it's not as simple as many think. Reading the VIX and profiting from it takes much more than anticipating a choppy market after big economic news or predicting lingering fear among investors for months to come.
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The fact is that nothing you can trade on Wall Street moves exactly like you would think. And the VIX is no different.
But that's not to say trading the VIX or watching the index doesn't have its benefits. Here are a few myths about the index followed by the reality.
Reality: You can buy and sell VIX futures. That is a very big difference. VIX futures can (and always do) trade at premiums or discounts to the VIX. In fact they almost always trade at premiums to the VIX and that affects your potential profits. Read more about how to hedge with the VIX.
Reality: The VIX isn't a blue-chip stock or a piece of real estate. VIX futures cash out when they expire, based on a VIX settlement price. So unless you roll out, your position will vanish.
Reality: VIX futures price based on where the market expects to see the VIX on a given date in the future, the day the VIX expires. That estimate may or may not move on a given day with a move in the VIX. The further out in time, the less it will track VIX moves.
Reality: Well, the iPath S&P 500 VIX Short Term Futures ETN /quotes/comstock/13*!vxx/quotes/nls/vxx (VXX 18.61, -0.64, -3.33%) does trade like a regular stock, but it does not track particularly well. In fact it underperforms over time so long as VIX futures trade in an upwardly sloped term structure. And VIX futures virtually always trade in an upwardly sloping term structure. Read about two new ways to trade market volatility.
Reality: Run, don't walk, from anyone that tells you about a key chart point on VXX. VIX is a statistic, VIX futures trade based on estimates on a forward price for that statistic. VXX creates a constant duration 30-day VIX future, and loses money each day simply rolling from the nearest month future to the next month out if the next month out trades at a premium. Hence VXX is really just a number relative to itself the day before, it's the tail of a tail of a tail of a dog.
Reality: VXX works fine as a short-term trading vehicle. On a day to day basis, it will track about 50% of the VIX move. But it works terribly as a portfolio hedge for the reasons I just stated. It loses money over time in an upward sloping VIX term structure. Owning and rolling 2-month to 3-month VIX futures yourself works better if you're hedging.
Reality: Well, the iPath S&P 500 VIX Mid-Term Futures ETN /quotes/comstock/13*!vxz/quotes/nls/vxz (VXZ 86.89, -1.51, -1.71%) has done relatively well since inception. The difference between VXX and VXZ is that the latter tracks 4-month to 7-month VIX futures instead of 30-day VIX futures tracked by the former. As a result VXZ has no "contango trouble" like VXX as the VIX curve gets pretty flat out that far. But I would caution that VXX and VXZ only listed in January 2009, and thus neither has had to show its mettle through a VIX storm. 4- to 7-month VIX futures hold their premium to VIX almost always, but would move to a significant discount in a serious VIX explosion. In 2008 they lagged by 20 to 30 points. So I suspect VXZ would not provide great protection when you wanted it most. It's a fine volatility proxy in a quiet market, but if the goal is insurance, it may disappoint. Read about what a record breaking VIX means for investors.
Reality: Well, I don't agree with that. But I can't prove it wrong. I will say this: VIX is a mean-reverting statistic. High VIX, excessive VIX call buying (and actual SPX put buying, or betting against the S&P 500 Index /quotes/comstock/21z!i1:in\x (SPX 1,109, +9.71, +0.88%) ) represent extremes in nervousness and/or bearish sentiment. In theory, that's a time you want to actually buy, not sell. But take that with a major grain of salt, because trends do take on a life of their own, like the VIX explosion and market implosion of 2008.
Adam Warner is a proprietary options trader with Addormar Co. Inc. He is the author of "Options Volatility Trading: Strategies for Profiting From Market Swings ." He is currently options editor at Minyanville.com and a contributing writer for InvestorPlace.com .
Coming soon to a Best Buy near you: Amazon.com's Kindle e-reader. And not a moment too soon.
58 min ago11:16 a.m. Sept. 9, 2010 | Comments: 1
- Mkthinker | 8:55 a.m. Today8:55 a.m. Sept. 9, 2010
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