VIX Futures: 5 Ways to Profit at Major Market Bottoms
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VIX, short for volatility index are probably one of the most popular of the derivatives instruments. VIX is often quoted in the financial media especially when the equity markets make strong and sudden moves. It is also given the nickname of the 'fear index,' although there is nothing fearful about if for an informed futures trader.
The VIX is often used by professional traders to find a market bottom. The reasoning behind this being that as the average investor is likely to sell their positions in fear of a market drop. When the VIX levels are relatively high, it usually results in weak long positions being flushed out of the market, thus forming a major market bottom as a result.
The VIX futures are standard contracts based on a forward 30-day implied volatility of the S&P500 index. The VIX futures contracts track the underlying which is the VIX index. The unique characteristics of the VIX futures index are that they often tend to be higher or lower than the underlying VIX index itself. This basically tells the trader's expectations of the expected volatility of the S&P500 Index.
Interestingly, the VIX tracks the SPX options market and not the broad stock market. This is because the options markets for the SPX are actually large and made up of institutional investors.
The VIX futures are also known as the CBOE Volatility Index futures or VX for short. It is a relatively new addition to the family of futures instruments, having been listed since 2004. The VIX index is based upon real time prices of options on the S&P500 Index, listed on the Chicago Board Options Exchange (CBOE).
In order to profit from the VIX futures, the trader must first understand what the VIX futures mean.
How do the CBOE VIX Futures work?
The VIX futures allow traders to speculate on the volatility of the VIX index, which is derived from the S&P500 index. The VIX is computed based on the option prices for the S&P500 index. The SPX options basically estimates on how volatile the S&P500 index will be between the current day and the expiration date of the options contract. The estimates are implied based on how much buyers are willing to pay.
Higher volatility often results in higher premiums for the options while in a flat or quiet market; the premiums obviously are a lot cheaper.
The most common method employed to derive the volatility information from the options prices is based on different SPX options which results in an aggregate value of the volatility. There are many academic research papers into the calculation of the VIX which can be easily accessed for those who want the finer details on the VIX calculation.
To put it generally, when the market starts to dip lower, investors, fearful of losing their equity tend to purchase SPX PUT options. This behavior results in higher premiums for the PUT options, which leads to a spike in the VIX index, which eventually shows up over a 30-day period.
The chart below shows the E-mini S&P500 futures and the CBOE VIX index. It is not hard to miss the market bottoms coinciding with the spike in the VIX index.
The VIX futures or the CBOE VIX index offers as a good barometer into the investor sentiment, which can be used by traders to catch market bottoms.
VIX Futures Contract Specifications
The CBOE VIX futures contracts are the futures on the CBOE volatility index or VIX which forms the underlying asset. Unlike other commodity contracts, there is no physical settlement for the VIX, it is just a number, and therefore all VIX contracts are cash settled. The final settlement date for the VIX futures contracts are 30 days before the third Friday of the following month. Generally, VIX futures contracts expire on a Wednesday with the last trading day falling on a Tuesday.
The ticker symbol for the VIX futures are VX, with different futures brokers using other names such as VIX or VI. The futures contracts for VIX come with a monthly expiration and there are a total of nine serial contract months available at any point.
Contract and tick size
Each VIX futures contracts 1000 units. In other words, the contract multiplier is 1000, or 1000 times the respective forward VIX index value. The minimum tick size is 0.05 VIX points or equivalent to $50. The VIX futures contracts trades during the regular hours from 8:30 - 15:15 CT and trade during the extended hours from 1700 CT on Sunday through 15:15 on Friday close. There is a 15-minute break every day from 15:15 - 15:30.
VIX Futures Contract Summary
How to profit with VIX futures contracts
Firstly, it is essential to know that the VIX index usually ranges. Therefore there are no significant trends that are formed and swing trading on the VIX futures is practically out of question. Furthermore due to the volatile nature of the VIX index, being caught on the wrong side of the market can cost you very dearly, but at the same time, being on the right side of the market can be very rewarding.
The above chart shows a 10-year price history for the VIX futures. You can see that the index oscillates between 60, reached in late 2008 and bottoms out near 10. If you have considered trading the VIX futures, here are some ways to profit.
#1 - Mean Reversion
Mean reversion is one of the techniques used by traders especially on volatile assets. The basic premise in using a mean reversion strategy is that when price tends to rise sharply, more often than not, price tends to pull back to the mean.
In this approach, a moving average of some kind is used. One of the methods to trade this approach is to wait for volatility to spike. Bear in mind that the VIX tends to spike, especially if you watch on a daily basis. If these spikes do not coincide with a market bottom, there is a good chance that the VIX spike is more likely a fake spike to the upside and could signal future spikes to come, putting the question about mean reversion.
The chart above shows a few instances of trading set ups where the spike in the VIX index coincides with a bottom in the S&P500 futures. Using this as a confirmation, traders can then look to go short on the VIX targeting the 10 period EMA.
#2 - Trading based on the VIX/ES chart
A unique approach to trading the VIX is by making use of additional market information from the ES chart as well. By using a ratio chart for the VIX and the ES futures contracts and applying a moving average crossover method, traders can look at potentially profitable trade set ups in the short term.
In this approach, the main basis for the long or short positions comes by the moving average signals from the VIX/ES ratio chart, as shown below.
Here you can see that the main ratio chart on the left shows a buy signal on the VIX/ES, which means that you go long on the VIX futures (and potentially exploit this by going short on the E-mini S&P500 futures as well). The bullish moving average crossover shows the levels and the corresponding arrows on the chart shows the long signals on the VIX and short signals on the ES futures.
#3 - The VIX Index and VIX futures divergence
Divergence trading is a powerful way to capture short term momentum led explosive moves in the markets. With the VIX futures, traders can employ similar methods of trading the VIX futures.
In this trading method, you simply compare the CBOE Volatility index, VIX and the VIX futures to the highs or the lows, depending on if you want to go short or long.
The chart below shows the VIX index on the top and the VIX futures chart on the lower half. The areas marked by the red line connecting the highs shows areas of price divergence. Following this divergence, the VIX futures often results in a strong sell off.
#4 - VIX Contango and Backwardation
Contango and backwardation are two aspects that govern futures markets regardless of the underlying asset. The VIX futures are no different. Contango in VIX futures is the normal, where the price of the current month futures is lower than the price of the far out VIX futures contracts. This simply denotes the fact that investors expect volatility to rise in the future.
Backwardation in VIX futures is where the front month contract prices are higher than further out contract month prices. It is widely accepted that backwardation often results in the S&P500 likely to turn bearish in the near term.
To utilize this approach to trading the VIX, traders need to keep an eye out on two contracts, which is the current month contract and the next month's contract.
Contango and Backwardation can also be compared between the spot and the current month VIX contracts. When the spot VIX closes higher than the current month VIX contracts, it signals backwardation. This closely ties into the previous method of VIX divergence that is described.
#5 - Analyzing the S&P500 Markets
Another simple approach to trading the VIX futures is to analyze the S&P500 market itself or the E-mini S&P500 futures. In this approach, the futures trader can conduct a long term analysis of the S&P500 market and then wait for price to reach the specified/identified support level. When this coincides with a peak in the VIX futures, it can serve as a confirmation to go short on the VIX futures.
The above chart shows the ES markets on the top and the VIX futures below. Technical analysis on the ES markets can be used to confirm the bottoms and the peaks in the VIX futures. Using the additional information on a very short term basis can help VIX traders to capture the short term momentum led set ups on the VIX futures.
The above methods merely outline some of the ways traders can employ techniques in trading the VIX futures. There are more complex trading strategies, which require a mix of complex mathematical equations and looking to other VIX products as well. Traders who prefer such kind of VIX trading strategies can definitely explore them in more detail, however there is no guarantee that the more complex a trading strategy is the better the returns.
For an the average retail futures day trader, the above methods to trade the VIX futures can form a good starting point in the markets before you can advance to more complex trading methods to trade the volatility futures.