How to Trade Volatility — Part 3 Volatility Pairs Trading
As we’ve covered earlier this week, trading volatility with VXX or XIV can produce substantial opportunities for active traders and investors. Fully understanding the features and risks of the different volatility vehicles available is crucial, but so too is taking a broader look at the markets and hedging your positions with pairs trading.
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Utilizing a pairs trading strategy is a valuable method for limiting personal portfolio volatility. The same ideas surrounding the movement differences between two stocks and their converging gaps are applicable in trading volatility with another investment vehicle. Just like you can pair two different stock positions in the same sector to hedge against prospective losses, traders can pair positions in volatility with market index ETFs like SPDR S&P 500 (SPY), ProShares Short S&P 500 (SH), and also with the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ).
The SPY ETF is a large blend fund that correlates (for the most part) with performance of the S&P 500 Index. Tracking the S&P 500’s performance in a direct correlation, SPY can also protect against loss when the market moves against your volatility positions. This makes it a quality short-term trading strategy when paired with volatility.
SH ETFs correlate with the daily inverse performance of the S&P 500 and can be implemented as a hedging vehicle against a long position in Daily Inverse VIX Short Term ETN (XIV). A long position in SH can be used as an excellent pairing instrument as it directly benefits from overall market volatility. As a non-leveraged ETF, SH follows the S&P 500 on a direct 1-1 correlation in the inverse direction. Inverse ETFs like SH are a unique tool to be used to capitalize on market movement with great flexibility.
Another way to construct a volatility pairs trade is with positions in the VXX and the longer 4-5 month period VXZ mid-term futures ETN. The VXZ tracks mid-length futures contracts on the S&P 500, but does not move in such an extreme manner as the VXX typically does. Hedging a paired trade with VXZ can limit losses in a high-volatility situation. If the two are paired correctly, they can potentially lower the volatility of your position and provide overall smoother returns.
To wrap up the series, next week we’re going to cover options trading strategies by considering volatility in order to maximize favorable pricing in your trading.
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Larry Connors is CEO of Connors Research
Cesar Alvarez is Director of Research of Connors Research
Joshua Glasgall is Senior Editor of Connors Research