:max_bytes(150000):strip_icc()/midsection-businessmen-analyzing-charts-on-laptop-in-office-1128046391-f4eda1281ff34edfbe64a6b12454ca5d.jpg "How to Day Trade Volatility ETFs")
Volatility exchange traded funds (ETFs) and exchange traded notes (ETNs) can sometimes offer interesting day trading opportunities in volatile markets. At other, less volatile times, volatility ETFs should be left alone.
A volatility ETF will typically move in the opposite direction to major stock market indexes, such as the S&P 500 Index or the Dow Jones Industrial Average.
For example, when the S&P 500 is rising, volatility ETFs and ETNs—such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX)—will typically decline. On the other hand, when the S&P 500 is falling, volatility ETFs and ETNs will usually rise.
Key Takeaways
- Day trading volatility exchange traded funds can be attractive when markets are volatile.
- An ETF is an exchange-traded fund which holds the underlying assets of an index.
- An ETN is an exchange-traded note, which does not hold any assets and is structured as a debt security.
- Volatility ETNs, such as VXX, will quite often lead the S&P 500; when this occurs, the signal lets you know whether to be long or short.
- VXX usually sees explosive moves when the S&P 500 declines, and they typically far exceed the movement in the S&P 500.
ETFs vs. ETNs
Although all are commonly referred to as volatility ETFs, some are actual ETFs and others technically are ETNs.
An ETF is a fund that trades on stock exchanges and holds assets that are in the index that it tracks. An ETN is an exchange traded note, which also trades on exchanges, but is structured as a debt security and does not hold any assets.
ETNs don’t have the tracking errors that ETFs may be prone to because ETNs only track an index. ETFs, on the other hand, invest in assets (again, those held in a benchmark index), and the value of those assets can deviate from the index itself.
When divergences happen, they can create discrepancies between the performance of the ETF and the index it is supposed to represent.
Nevertheless, ETFs and ETNs are both acceptable for day trading volatility, as long as the ETF or ETN being traded has a lot of liquidity. Liquidity is measured by trading volume or the number of shares traded each day.
Choosing a Volatility ETF/ETN
There are a variety of volatility exchange-traded funds to choose from, including inverse volatility ETFs. An inverse volatility ETF will generally move in the same direction as the major stock market indexes (the opposite/inverse direction of traditional volatility ETFs).
When day trading, a simple ETF/ETN with high volume is usually the best choice. The iPath S&P 500 VIX Short-Term Futures ETN (VXX) is the largest and most liquid in the volatility ETF/ETN universe.
-69.91%
The one-year daily total return of iPath S&P 500 VIX Short-Term Futures ETN (as of Jan. 16, 2024).
How to Day Trade VXX
VXX usually experiences explosive moves when the S&P 500 declines. They typically far exceed the movement seen in the S&P 500. For example, a 5% drop in the S&P 500 may result in a 15% gain in VXX. Therefore, trading VXX provides more profit potential than simply shorting the SPDR S&P 500 ETF Trust (SPY).
Since VXX has this tendency for major gains on declines in its benchmark (the Standard & Poor’s (S&P) 500 Index) when the S&P 500 rallies again, VXX typically sells off in a dramatic fashion.
Day traders have two ways to profit:
- Buy VXX when the S&P 500 is declining.
- Short VXX following a price spike, once the S&P 500 begins to rally higher again, and VXX is falling.
Depending on the size of the trend in the S&P 500, favorable trading conditions in VXX can last for several days or up to several months. The charts below show a short-term decline and reversal in the S&P 500 and the corresponding rally and selloff in VXX.
The charts confirm that VXX has a tendency for big moves. The ETN (top chart) rallied 105% based on an 11.84% decline in the S&P 500 (bottom chart). It then fell 31.6% when the S&P 500 bounced 10% off the low. Such are the times that day traders will want to be trading VXX.
When the S&P 500 is in a quiet uptrend with little downside movement, VXX will decline slowly. These times are not ideal for day trading. The big opportunities for day trading come during and in the aftermath of a several percentage point decline or more in the S&P 500.
VXX Can Signal a Change
Volatility ETFs or ETNs, such as VXX, will quite often lead the S&P 500 Index. When this occurs, it signals which side of the trade you want to be on (long or short). For example, the charts below provided several clues that the S&P 500 would move higher.
VXX (top chart) was weaker in the morning, moving lower overall even when the S&P 500 (bottom chart) made a lower low. Then, VXX broke its major support level just after 12 p.m., indicating that the S&P 500 could eventually break through its resistance level. It did so about 30 minutes later.
VXX won’t always lead the S&P 500. Sometimes the S&P 500 will lead, which can also provide us with clues for day trading VXX.
Entry and Exit Points
The biggest intraday opportunities occur in VXX when there is a significant drop (or subsequent rally) in the S&P 500. During such times, the following entry and stop points can be used to extract profit from the volatility ETN.
The charts below provide an example. At 10:43 a.m., the S&P 500 (bottom chart) has just made a lower low and then starts to rally. At that same time, VXX (top chart) is well below its high and is forming a sideways channel (highlighted by the rectangle on the chart).
The S&P 500 continues to rally. A day trader should now be piecing together that VXX is weak (lower low) and that, if the S&P 500 is rallying, then VXX is likely to start dropping soon.
Entry Point
Wait for a trade trigger. This is an event that actually tells you the price is starting to drop. In this case, VXX is moving in a channel or a small consolidation above $33.38. If the price drops below $33.38, then the channel is broken, and, given the other pieces of evidence, a short trade in VXX can be taken.
Exit Point
Placing a stop-loss order at $0.02 above the most recent high (which occurred just prior to entry) makes sense to protect the short position. If going long, a trader should place a stop-loss order at $0.02 below the most recent low that occurred just prior to entry.
Alternatively, set a target that is a multiple of risk. If your risk on a trade is $0.14 per share, aim to make a profit at two times your risk (or $0.28). For example, the short trade above was initiated at $33.37 with a stop-loss order at $33.51. The distance between the entry and stop loss is $0.14.
Therefore, aim to make at least $0.28 on the trade (two times risk) by placing the target $0.28 below entry at $33.09. This two-times-risk multiple is adjustable based on volatility. In very strong trends, profits may even equal three or four times the amount at risk.
The same method applies when VXX is strong and the S&P 500 is weak. VXX will be moving higher; wait for a pullback and a pause or consolidation. Then, when the price breaks above the top of the consolidation, enter a long position. Place a stop-loss order just below the low of the pullback.
When To Exit
Exit trades if you notice the overall trend in the market shifting against you. If you are short, a higher swing low or higher swing high indicates a potential trend shift. If you are long, a lower swing low or lower swing high indicates a potential trend shift.
If the volatility ETN isn’t moving enough to easily produce gains which are twice the amount that you risk, avoid trading until volatility increases.
What Is the VXX ETN?
The VXX ETN is based on the VIX—the Chicago Board Options Exchange Volatility Index. The VIX reflects investors’ expectations about the short-term direction of the S&P 500 by assessing current prices for put and call options tied to the widely followed index. The VIX produces an educated guess about how much the index is likely to move over the next 30 days. Traders who want to profit from bets on volatility in the market might invest in the VXX.
What Does It Mean When the VIX Is High?
The VIX, or the volatility index, measures volatility in the stock market. When the VIX is high, it means that volatility is high. High market volatility is usually accompanied by market fear.
Are ETFs Good for Day Trading?
Exchange traded funds (ETFs) have emerged as another instrument of choice for day trading. ETFs offer the diversification of a mutual fund, the high liquidity and real-time trading of a stock, and low transaction costs.
How Long Does an ETF Trade Take To Settle?
An ETF trade typically takes two business days to settle (trade date plus two business days).
The Bottom Line
Volatility ETFs and ETNs usually have larger price swings than the S&P 500, making them ideal for day trading. The greatest opportunities (in terms of percentage price moves) come during, and shortly after, the S&P 500 has significant declines. A volatility ETN, such as the iPath S&P 500 VIX Short-Term Futures ETN, may even foreshadow what the S&P 500 is going to do next.
Exiting all trades when the market turns against you is a good way to limit risk. Profits should be larger than losses. This way, even if only half the trades are winners (profit target is reached), the strategy is still a profitable one.
If you can’t reasonably expect to make a profit at least two times your risk based on that day’s volatility, then don’t trade using this strategy.