Taking Advantage of Market Volatility with an Uncommon Approach

Taking Advantage of Market Volatility with an Uncommon Approach

The recent volatility in equity, bond, commodity and foreign exchange markets has severely impacted many trading and longer-term portfolio positions. Retail traders are always looking for that hard-to-find edge, especially in these market conditions. One edge that a trader has is that, unlike many institutional investors, a trader can pick and choose when and how to commit capital. Many portfolio managers don’t have that option – they often can’t sit on the sidelines as new investment money comes in; they are required to make investments and put that money to work. A second edge that traders have is access to tools that help guide when and how to commit capital. One great tool is the Masters In Trading VIX Trading System.  The VIX Trading System uses a proprietary approach to analyze movements in the VIX term structure and looks for specific conditions to issue a buy signal on the S & P 500.  In general, the system is looking for a spike in the VIX, then a pull back and, based on very specific VIX term structure criteria, will issue a buy signal for the Index.  Let’s review the results of the System and several approaches to trading the signals.

What are the Results of the VIX Trading System

The VIX Trading System is looking for certain conditions in the VIX term structure to issue a buy signal on the S & P 500 ($SPX) with the objective of realizing a 100-point increase in the Index (or a 10-point increase in the $SPY).  Here are the 4 successful buy signals just from this year (4 winners, 0 losers):

Over the last 5 years, there have been 14 successful signals and 0 (yes, zero) losers.

How To Structure a VIX Trading System Buy Signal Trade

Structuring a buy signal trade is based on the trader’s preferred risk relative to desired potential return.  Since the signal is based on the volatility and movement of the S & P 500, the $SPX or the $SPY are generally used as the underlying instrument.  If a trader wants a limited or capped risk (in other words, not lose more than what is invested in the trade), then call options are the best choice.  If the trader is willing to accept additional risk or has a larger account, then futures or stock may be the way to go.

If a trader is buying options, what expiration should be used?  There are times when the $SPX moves over 100 points almost immediately after the signal.  However, there are other times when the signal may take longer to play out and, in fact, the $SPX can initially move down.  Options 4 to 8 weeks until expiration is a good starting point.

Should a trader buy in the money (ITM) or out of the money (OTM) call options or maybe even a call spread?   Definitely use ITM options or a spread.  The trade is entered when volatility is relatively high.  The OTM call option’s value is highly dependent on implied volatility.  When the $SPX rallies, volatility will drop (often significantly).  This is extremely important:  the OTM call option can lose more value due to the declining volatility than it may gain due to the favorable price movement.  So, the trader and the signal are right on direction, but the option may actually lose money. A painful lesson to learn.

How To Structure an Options Trade for the VIX Trading System Buy Signal

If a trader has limited capital or is relatively new to this trade, $SPY options are probably the best choice.  It’s important to size the initial trade entry to have enough capital to add to the trade to build a position if the $SPX/$SPY initially moves down after the buy signal.

One approach would be to buy a call.  Based on today’s prices with $SPY trading around $402, a 55 delta $SPY call, 30 days until expiration would cost about $1,300 (the maximum risk).  Although there is a large potential profit, this is still a significant amount of capital for many traders, especially if the $SPX/$SPY pulls back, and a trader wants the opportunity to build additional positions.

A less capital-intensive approach is to buy a call spread – simultaneously buy a call option and sell a higher strike call option with the same expiration.  This lowers the amount of the investment but also limits the potential gain (no free lunch in trading!).  It takes advantage of the relatively high volatility by selling a call to help pay for the long call.  For example, buying a $SPY at the money call and selling a call 10 points higher (the target of the buy signal) 30 days until expiration (in this case a $SPY $402 – $412 call spread) would cost about $490 (the maximum at risk).  If the $SPY is at $412 or higher at expiration, the spread would be worth $1,000 or a profit of $510 on a $490 investment!  A trader can change the reward/risk ratio by changing the width of the spread.

There are many other ways to initiate long positions based on a VIX Trading System Buy Signal.  There are many ways to get creative through the use of futures, options or even stock using other Indices such as the NASDAQ or the Russell.  If you’re new to trading or this approach, paper trade before risking your hard-earned money.  And remember, sizing your trades relative to your risk parameters and trade management are more important to your success than a perfect trade entry point.

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