Trading the Volatility. Part 2

The VIX and its inverse relationship with the markets:

The VIX, as a contrarian indicator, is an incredible weapon for technical traders to determine extreme conditions of bullish or bearishness of the market, using its inverse relationship: when the market is rallying, the VIX tends to drop; when the market is tanking the VIX tends to rise. Smart and serious investors use it to bet against the crowd when its greed (or fear) levels are high. And mainly, they use it as protection or hedge for their investments.

The VIX, also known as the 'fear gauge', measures the frequency and intensity of changes in the SP500 in the short-term (30 days), through the implied volatility IV of its at-the-money call and put options. A level below 20 generally indicates a bearish or complacent market, while reads above 30 are generally associated with a large amount of volatility, and mean that investor fears are taking place.

Smart traders usually "buy bargains" when volatility is high, taking advantage that the crowd is panicking closing positions: in a market sell-off, they are more inclined to buy VXX (the ETN that replicates the VIX behavior) puts or SPY calls as protection or as a speculative position without too much concern for the prices they have to pay. On the other side, with low volatility, and as long implied volatility is low, seems a good opportunity to buy VXX calls or SPY puts at reasonable prices as a protection for our portfolio. Investors who want to trade the VIX should keep in mind that VIX-linked products are short-term trading instruments, only for traders who know the risks.

How to play the VIX

First of all, is important to tell that isn't easy to trade the VIX: it's like an art. Experienced traders know that. It special behavior forces you to take jealous control of your trade. That's why is best make VIX trades only in the short-term. And, after trying in different timeframes, I get better and more clear results in the daily chart.

There is a chart that I always have visible on my Thinkorswim platform: the daily of the VIX with just two studies: the Bohlinger Bands and its moving average SMA200. As we know, the Bollinger Bands is a popular technical indicator to determine overbought and oversold conditions. In a range-bound market (as VIX accustoms) the BB works even better as prices travel between its two "rubber bands". On the other hand, the Simple Moving Average 200 a dynamic support-resistance level, and probably the most used and reliable average used by traders and investors, including smart investors. An example of its power and influence in the markets could be observed recently last year in December when a falling SPX index touches its SMA200 and originated an amazing rebound that lasts until today.

The candles represent the VIX daily price action, the grey line is the SP500, always in opposition. In purple, the upper and lower bands of the BB. The blue-sky dashed line is the SMA200. The VIX behavior with these two indicators is typical, so is a good idea take advantage of it in our trades.

Look at the chart above, taken from the past year 2018. First, verify the inverse correlation between the VIX and the SP500 index SPX. It happens all the time, like a mirror image. Second: as the VIX trades, its value raises or falls, as it bounces off the upper or lower band of the Bohlinger Bands. So:
- Go long in VXX when the VIX falls to the lower band of the BB. At that moment the market is at a peak and began a pullback, as you see in the chart.
- The same idea, but contrary, is used for the upper band of the BB: go short in VXX, and verify the SP500 began to rebound.

There are many more complex option strategies (spreads) to take advantage of this situation, that I will analyze in a future post.

Now, check the SMA200. Last year was a very difficult resistance (then support) for the VIX to overcome. Review other years and verify that its a typical behavior of the VIX with its SMA200. Since August it rebound many times in that level (in the yellow circles). Finally, after three attempts, in early October the VIX breached its SMA200, and the SP500 now reversed dramatically. These breakouts are very attractive entry points for a disciplined trader. Notice that in early November and December, with the SMA200, now as support, had two new failed attempts to crossover it. And today, with the VIX in 16.14, is in its third attempt, so pay attention with the volatility behavior this week.

Strategy using the VIX spikes

This simple strategy is focused on the VIX daily chart. I suggest in this case, when trading, forget the SPX chart because, although they are inverse, this moves in a tendential way, different from the VIX that does it in very marked ranges, and can create confusion and anxiety for the novice trader. Even sometimes there are divergences between the two that can complicate more the analysis.

More than a strategy, its a tip when trading the VIX. In its daily chart notice the clear difference between its relative tops and bottoms: tops are spikes, like an inverted V, while bottoms are more rounded.
- In the tops, this is because fear is the predominant feeling, that very fast becomes in panic. This rapid rise is usually followed by a bearish candle when the smart investors decide to start trading.
- On the other hand, in the bottoms of the VIX chart, the market is more complacent, greed is in charge of the traders' feelings and so the SPX costs more to fall, that's why bottoms are slower and full of false signals.

The diligent trader has already grasped the idea of this strategy: trade in the spikes of the VIX daily chart, operating shorts or puts. To find an acceptable entry point, the Bohlinger Bands are useful: waiting for the moment when the bullish candle leaves the upper band with some slack. Then expect a next bearish candle that wraps it completely (or almost) the previous bullish. This candlestick is known as engulfing. The open of the next candle is my entry point. Everything very simple. However, there are a couple of undefined points in this strategy. One of them is not being clear about the exit. Perhaps the best idea is to set in advance a risk-reward, like the popular 1: 3 used by many traders, to determine the exit.

The other complicated point of this strategy is the location of the stop loss. The usual is that the VIX continues its fall the following days and is difficult it returns above the engulfing candle, however, it can happen. A double top would be formed, the most reliable figure in the technical analysis according to Alexander Elder, where we could confidently sell the VIX. The best plan is to trial daily the stop loss to a safe level.

The "VIX spike strategy" works best in its daily chart. Every year happens, few but powerful. In this chart, taken from 2015, we noticed two big spikes overcoming the upper band of the Bohlinger Bands (mid-October and mid-December, in the yellow circle), both followed by an engulfing candle that generates the quick and important reverse. Two more spikes happen in January and February 2016 (also in a yellow circle) but in both cases, its price didn't overcome the BB, so its reverse isn't as powerful as the 2015 spikes. Finally, in the pink circles, we had two spikes that haven't an engulfing candle enveloping them, so the reverse seems very unclear.