Volatility / Vix Trading: Your Step-by-Step Guide to Stock...

Volatility/VixTrading

YourStep-by-StepGuidetoStockTrading

andOptionsTradingwithVolatility

TableOfContents

Introduction

Chapter 1 – What IsVolatility?

Chapter 2 – The VolatilityIndex

Chapter 3 – Volatility asInsurance

Chapter4–HowtoTradetheVIX

Chapter 5 – VolatilityTradingStep-by-Step

Chapter 6 – IdentifyingMarketTrends

Chapter7–Warning&Tips:TheInstitutionalInvestors

Chapter8–FinalNotes

Conclusion

IntroductionI want to thank you verymuch and congratulate youfor downloading the book,Volatility/Vix Trading– YourStep-by-Step Guide to StockTradingandOptionsTradingwithVolatility.

This book is the ultimatebeginner’s guide to tradingwith volatility and the

VolatilityIndex(VIX).

In this book, you'll discoverwhat volatility is and how itworks, and you'll learn step-by-step how to use volatilityand VIX to identify markettrends and tradingopportunities.

Thanks again fordownloading this book, Ihopeyouenjoyit!

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Chapter 1 –What IsVolatility?

Whatever financial asset youconsider it has a price everyday or every moment of theday.Clearlythepriceschangeeverydayoreveryminuteofeach day and thesemovementsarerepresentedinpricecharts.

Every day the prices reach aminimum and a maximumlevel and this difference iscalled fluctuation. If in acertainperiodoftime,suchasthree months, the fluctuationis higher than that registeredin the same previous periodof time, we say that thevolatilityishigher.Let’stakean example: if today thecurrency pair EUR/USD hasamaximumpriceof1.40andaminimum of 1.37, whereas

yesterday it had a minimumof 1.385 and a maximum of1.40, you can see that thevolatility today is higher(0.03versus0.015).

AnIn-DepthLookatVolatility

Usually, volatility isconnected to the uncertaintyof thefinancialmarketsor toanunstableeconomicoutlookof a company, country ormacroeconomic area. Thisnormally happens whenthere’s a crisis or someeconomic or macroeconomicfactorsthatmaygenerateit.

Psychologically,manytradersand investors are forced tobuy or sell their financialassets toprotect their capital,or to reduce their losses byopting for sheltergoods suchas gold or the US dollar.When the markets do nothaveacleardirection likeanuptrend or downtrend, theprices look like arollercoaster and theyfluctuatedramatically.

Eventhoughitcanbeseenasharmful for your investment,volatilitycanalsorepresentagreat opportunity to makesomeprofitsifyouareabletotakeadvantageofit.

In order to measure therelativevolatility of a certainstock to themarket, theBetais used. This parameter isrelated to the relevantbenchmark: if the stock isincluded in the S&P 500’s

list, the referencewill be theS&P 500 index. How it iscalculated? It considers thereturnsofthestockversustheindexones:ifthesecurityhasabetavalueof1.2thismeansit moved 120% for every100% move in thebenchmark. If a stock has abeta value of 0.8, it moved80% for every 100% indexmove.

However, themost important

parameter used to measurevolatility is the so-calledVolatilityIndex(VIX).

Chapter 2 – TheVolatilityIndex

WhatistheVolatilityIndex?It is used to identify themarket expectations in thenear term. It has beenconsideredfora long timeasa valuable tool to understandinvestor sentiment andvolatility, or to measure theperceived risk of the

investors. If they areexpecting or perceiving ahigher risk or if they aremostly buying protection putoptions, the VIX will behigher and the market willprobablydrop.

In fact, theVIXgrowseverytime the markets are facinguncertainty or are “nervous”and decreases whenever themarketsaregrowing: there isa contrarian correlation

betweenthetwofactors.Soifyou look at the VIX andobserve its movements, youwill probably know thedirectionofthemarkets.

Let’stakeanexample:ifyouare an investor who hasboughtalotofstocksandyouare now concerned that themarket could face adownwards trend, youwouldbuyprotectionput options toprotect your stock

investments. Moreover youwould stop buying stockssinceyoucouldlosemoneyifthe market prices drop. If alot of large investors stoptheir purchases in this way,the markets won’t grow andtheywillprobablyexperienceadowntrend.

Chapter3–VolatilityasInsurance

As it is considered animportant contrarian signal,let’s consider the followingchart.

.As you can see there is notalways an adversecorrelation, but usuallywhenthe VIX started to grow, theS&P 500 index fell.We cansee it in 1990, 1998, 2002-

2003andmostofallin2008.During these times, therewere financial “storms” likethe Gulf War, the Japanesestock market crisis, thescandals of Enron andWorldCom, the new war inIraqandfinallythesub-primecrisisthataffectedworldwidestockmarketsandeconomies.It could be considered as atype of insurance: it startsgrowing when the investors

perceive a higher degree ofuncertainty or when themarkets could drop. What isneeded now is to learn howand when to use the VIX:when it is low, it can createexcellentopportunitiestobuyprotective put options at areasonableprice.This is the best time toprotect your portfolio:whenthepriceislowandvolatilitycouldgrowinthefuture.

Chapter 4 – How toTradetheVIX

When can the VIX beconsidered low? Normallywhen it’s located below 15,it’s a good time to play theVIX.In fact, when the VIX is aslow as 15, the markets havegrown somuch that they arereadytogodownatacertain

point as it’s likely that theyhave reached a peak. Thiswill certainly happen but it’sdifficulttopredictwhen.When the VIX is low, inorder to trade in the simplestway,youneedtoconsidertheVIXfutures-exchangetradednotes (ETN) and exchangetraded funds (ETF) such asthe iPath S&P 500 VIXShort-Term Futures ETN (NYSE: VXX) or the S&P

VIXMid-Term Futures ETN(NYSE:VXZ).Why are we trading them?The ETFs and ETNs arecheaper and the futures canbeagoodguideline forwhatthe market directions mightbe. If you buy at a cheaperprice, your risk is lower interms of potential loss, butyour profits, althoughsomewhat protected, couldalsobemorelimited.

You should be protectedwhen the bullish period isoverorwhensomeeconomicnews might cause aslowdown.TheVIXwill starttogrow,andtheVXXandtheVXZwithit.IfyoubuyputswhentheVIXis low, it’s like betting thatthemarket isalmostnear thetop and will probably godown. Since the VIXmovements are the opposite

of the S&P 500 index,whenthe VIX is going up, it ismost likely that theS&P500willstartdropping.Another option is to buyleverage inverseETFs - suchasProSharesUltraPro S&P500 (NYSE: UPRO) orProSharesUltraShort S&P500 (NYSE: SDS). TheseETFswillallowyoutomakeprofitsevenwhenthemarketsaredropping.

Although the VIX is a stockmarket volatility index, youneed to understand that it’snot that different from anyother investment tool.It canchange in response to thenews,announcements,economicdata and dynamic marketexpectations.When you invest in a VIX-linked product, in fact, youshouldkeepinmindthatitis

a short-term investment andcarriesconsequentrisks.Thismeansyoushouldactfastandnot wait too long when itcomes to making investmentdecisions.Themostimportantthingyouneed to consider is that youcannotusetheVIXbyitself:you need to use it togetherwiththeS&P500index.

Chapter5–VolatilityTradingStep-by-Step

During panic times, the VIXtends to move moreaggressively than the stockmarkets. Let’s re-check thesamechart.

As you can see, during thefinancial crisis of 2008, theVIX grew by more than300% versus a total drop oftheS&P500ofaround50%.What does this mean? It

means that the VIXmovements are notproportionaltotheonesofthestock market. On average, a10% decrease in the stockmarket index may cause aVIXincreaseofbetween30%and50%.

Sothefirstpointyouneedtoconsider is that the VIXreacts more aggressivelyand not proportionally totheS&P500.

The second point consists inthe identification ofsentiment extremes. As wehave already seen, if weconsider the highs of thestockmarkets or the lows oftheVIX,wecanidentifyfearand complacency in themarket investors and thisnormallymeansanupcomingreversaloftheS&P500.

However, sometimes it cantake longer before the

reversal occurs. If we comeback to the chart, you mayhave noticed that the VIXcreated something of a rangemarket and stayed for a longtime between 10 and 15,values that are generallyconsidered to indicate apotential and upcomingreversalintheS&P500.

How could you identifywhether there’s a possibilityofreversal?Youneedtodraw

two lines: the first one is theresistance line correspondingto the high reached around2006 and the other is thesupport linecorresponding tothelowreachedin2006.

You can see that the VIXbroke the resistance line inthe second half of 2007 andcreated a second rangemarket with a resistance linearound 30. In 2008 thissecond resistance line was

again overcome by the VIXwhichreached80.

After reaching that peaktwice,theVIXdroppedtothelevels of 2007, except foranother peak of 50. If youalso look at the S&P 500trend, you can see that theVIX movements are inversecomparedtotheS&P500,andthe movements of the stockindex may help you in yourinvestmentdecisions.

Whatshouldyouhavedone?

When theVIXwas low,you could have boughtsome protection putoptions (or leverageinverse ETFs) and soldthe stocks when theresistance line wasbroken.When the VIX wasextremelyhigh, itwas agood chance to buy

stocks or some calloptions.

Chapter 6 –Identifying MarketTrends

TheVIXcanalsobeusefultoconfirmamarkettrend.Let’stakethesamechart.

As you can see, every timetheVIXpeaks,itcorrespondsto a lowordrop in the stockmarket. If you focus on theperiod 2003-8, you can seethat the stock market startedto grow again after thetensionsof thewar in Iraq in

2003 and the scandals ofEnron and WorldCom thataffectedWallStreet.

The VIX dropped to theminimum levels and thengrewagain:youcan also seethat in 2007 the VIX startedto grow, indicating a stockmarket reversal. The VIXincrease was confirmation ofinvestor sentiment that themarkets would dropsignificantlyin2008(thefear

was increasing and in fact“exploded” in September2008), in anticipation of thesub-prime crisis that affectedworldwide economies, butespecially those in EuropeandNorthAmerica.

The S&P index, in fact,droppedtothelevelsreachedin1996.

You can see another marketconfirmation in 2009: the

markets, after the low ofSeptember 2008, started torun again, and the VIXstarted to decreasesignificantlyagain.

PleasebeawarethatwhentheVIX movements are in arange, itmeans that typicallythe volatility is notconfirming the marketmovements (the so-calleddivergence) and the trendcould be short-lived. When

it’s more evident, it is morelikely to be confirming themarkettrend.

Chapter7–Warning& Tips: TheInstitutionalInvestors

We have established that theVIXmeasures thefearor thecomplacency of the marketstowards the financial oreconomicsituation.However,how can a single investor

understand how large theVIXmovementmightbe?Orhowlongamovecouldlast?

A significant part of theanswerconcernstheso-called“Institutional InvestorSelling”andtowhatextentitisoccurringatthesametime.Thisindexisdeterminedbyathree-dayexponentialmovingaverage and a six-dayweighted moving average.These two averages design

theshorttermsellingtrendbyinstitutionalinvestors.

This indicator has to becompared to, andmightevenanticipate, the VIXmovement.It is important tounderstand what is going oninthemarketasthiscanhelpin understanding where theVIXwillgo.

The Institutional Investorsnormally determine the

market trend, since they arethose institutions (banks orevencentralbanks)thatmoveenormous quantities ofmoney and are able todetermine an uptrend or adowntrend, speculativemovements or an increase ordrop of a single companysecurity.

These indicators can tell usmany things but not all: soit’s important to use more

charts in order to get thewhole picture and make thecorrectinvestmentdecision.

One prudent rule is that youshouldnevergoagainstwhatthe Institutional Investors aredoing asthatwould probablymeanalossforyou.YouareasmallinvestorcomparedwiththeseGoliathswithenormousamounts of money at theirdisposal. The general rule istofollowwhattheyaredoing.

Chapter 8 – FinalNotes

TheVIXisuseful toconfirmamarketdirectionandcanbea valuable signal tounderstandwherethemarketscouldgo.However, it shouldnot be used alone todetermine your investmentdecisions: you need tocompare it to the S&P 500

index and also use theInstitutional Investor Sellingindex which can anticipatebiginvestorsentiment.

However, uptrends in stockmarkets should be confirmedby a VIX downtrend, andstock market downtrends byan increase in the VIX. Ifthesecorrelationsarebroken,it is likely that the marketdirection will beunsustainable in the short

term and that a possiblemarket trend is just a short-term one.This wouldprobably indicate a rangemarket.

Agoodapproachinthatcaseistousepriceactiontrading.

WhentheVIXgetsclosetoapeak or a low, the currentmarket trend couldexperienceareversal,butthisreversal does not happen

immediately as you saw inthe previous chart. In fact,whentheVIXreachesarangelevelofbetween10and15orgoesover30,itcouldgrowordrop, but it is necessary asusual to also check the S&P500 index to get the overallpicture in order to try topredictadirection.

It is better to use moreindicators and indexestogether inorder tomake the

bestdecisions,andremembernot to go against theInstitutional Investors sinceyou could lose a lot ofmoney.

Conclusion

Thank you again fordownloadingthisbook!

You should now have theknowledge you need to getstarted trading use volatilityandVIX.

The next step is to takeaction!

Finally, if you enjoyed thisbook, please take the time toshare your thoughts and postareviewonAmazon.It’dbegreatlyappreciated!

Thankyouandgoodluck!

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TableofContents

IntroductionBonus: Download the FreeTradingToolkit

Chapter 1 – What IsVolatility?

Chapter 2 – The VolatilityIndex

Chapter 3 – Volatility asInsurance

Chapter4–HowtoTradetheVIX

Chapter 5 – VolatilityTradingStep-by-Step

Chapter 6 – IdentifyingMarketTrends

Chapter7–Warning&Tips:TheInstitutionalInvestors

Chapter8–FinalNotesConclusion