- Buy ProShares SVXY inverse volatility ETF. You definitely still want to exit if the market volatility starts climbing, but you have more time to react. In the post Timing Inverse Volatility with a Simple Ratio, I provide a straightforward method to time your SVXY entries/exits. It doesn’t work all the time but it will keep you out of big trouble like the February 5th, 2018 meltdown. SVXY attempts to match 50% of the opposite percentage moves of VXX. Since VXX only manages about 45% of the VIX’s percentage moves you should expect SVXY to have about a 25% move relative to the VIX. For more on SVXY see this post.
The current set of securities that attempt to track volatility include:
- Volatility futures contracts (CBOE VIX Futures)
- Options on volatility contracts (CBOE’s VIX options)
- VXX & VXZ ETNs with their ProShares competitors (rolling blends of futures contracts that trade like stocks). See this post for a complete list. See How to short VXX for specifics on shorting VXX.
- Options on VXX, VXZ, UVXY, SVXY, VIXY
- Inverse funds that attempt to go up when volatility goes down
- ProShares’ SVXY ETF (goal—daily 0.5X short term inverse returns). More info here.
All of these choices can be at least theoretically used to bet that the VIX index will go down. Futures contracts or VXX can be shorted, VIX or VXX puts can be bought, or calls shorted.
All of these choices have significant problems.
- None of them track the VIX index particularly well, they tend to lag the index considerably
- VXX can be hard to short (Schwab has had it in their “Hard to Borrow” category for a long time) and you can’t short stocks / ETFs/ETNs in an IRA account. Fortunately, SVXY is available,
- Long VIX / VXX put options have serious time decay issues—if the VIX doesn’t drop when you expect your positions bleed money.
- Because volatility products are relatively volatile the premiums on options tend to be expensive.
- Unhedged short positions leave you exposed to losses larger than your initial investment if you forecast incorrectly. Your losses if the index spikes won’t be unlimited because nothing goes up infinitely, but it could be enough to really hurt. Even the lethargic VXX managed rallies of around 2X in 2010, 2011 and 2018.
On the positive side of betting that the VIX index will go down, the VIX index and all of its proxies show mean reversion. After it spikes up, fear always subsides, and any surviving short position would reduce its losses over time and potentially turn profitable—assuming you didn’t get in when the VIX index was really low.
Better yet, short positions on VXX or similar products will also profit from the contango associated with the volatility futures these products are based on.
If you decide you want to go short on the VIX index, I think it makes sense to limit your potential losses if volatility spikes, either with stop-loss orders or with VIX or VXX OTM calls that would really kick in to limit your losses. Stop-loss orders are scary because if the market is gapping you might lose quite a bit more than your stop-loss order would suggest. For example, if you are short VXX at 40 and your stop loss is set at 42, your order might fill at 44 if the market gaps down significantly at opening. The type of stop-loss order that becomes a limit order rather than a market order when triggered prevents this scenario but opens you up to an even worse loss if volatility continues to spike and never trades at your limit price.
Even though it is scary, I think a stop-loss order would probably work well. At least looking back over the last couple of years, including the flash crash, the market was orderly enough to prevent large losses if reasonable stop-loss orders had been in place.