The power of the VIX and UVXY
On January 24, the Dow industrials were down 1,100 points before they staged an unprecedented comeback to close 86 points higher. That kind of extreme price swing is not supposed to happen. ETFs that track broad indexes like the Dow, NASDAQ, and S&P 500 typically shield investors from volatility.
But these are not typical times.
Concerns over the Federal Reserve’s looming interest rate hikes have whipsawed the markets. Since November, stocks have been on a roller coaster. They crash multiple days in row and then rally. But after just a day or two — right when investors think the pullback is over — stocks plummet again.
This is called volatility. Volatility is a measure of how much an asset price moves up or down, particularly in the short term.
In general, the more volatile an asset is, the more risky it is. Small-cap stocks and cryptocurrencies are good examples. If you are a more conservative investor who hates seeing big swings in your portfolio, it’s best to avoid volatile assets.
But what do you do if the entire stock market is experiencing extreme volatility?
Is there a way to protect your portfolio — and your emotions — from these punch-you-in-the-gut price swings?
Thankfully there is. In fact, you can even profit from volatility and extreme fear in the markets by trading a single ETF.
The ProShares Ultra VIX Short-Term Futures ETF ($UVXY) provides leveraged exposure to the S&P 500 VIX Short-Term Futures Index. It seeks results that are 1.5 times the daily performance of that index.
Wow…that last paragraph was a mouthful of jargon. Let’s break down what it means and why it’s worth your consideration. Spoiler alert: buying $UVXY protects you — and even lets you profit — from a market pullback.
Before we can understand $UVXY, we need to understand the Cboe Volatility Index, which is better known as the VIX. The VIX is a real-time index that represents the market’s expectations of volatility over the next 30 days.
You’ll often hear the VIX referred to as the fear gauge. That’s because investors use the VIX to assess the level of risk, fear, and/or stress in the market. When fear and volatility are high, the VIX rises. When the market is stable, the VIX decreases. For example, when fears over the Omicron Covid variant shook the markets a few months ago, the VIX spiked, and stocks crashed.
Volatility and risk play an enormous role in the price and success rate of options trades. For instance, if you place a bull-call spread, you want the market to increase at a slow and steady pace. That’s because when stocks rise too fast, they often pull back just as suddenly.
Volatility can destroy your short-term trades, not to mention significantly increase option premiums. That’s why it’s important to keep your eye on the VIX. When it’s spiking, it becomes difficult and risky to trade. It can also signal that a market pullback is coming.
Since the VIX is an index, you can track it just like you would the S&P 500 or Dow Jones Industrial Average. You can even profit off it by trading options. For example, if you think that market volatility is coming soon, you could buy call options or a bull-call spread of the VIX index ($VIX).
You cannot, however, buy shares of the VIX. That’s because you can’t own an index. An index is simply a tracking instrument.
Also, unlike the S&P 500, which has ETFs designed to mimic its performance (e.g. $SPY), there are no VIX ETFs. The best you can do is buy an ETF that is benchmarked to an index of VIX futures contracts. That’s what $UVXY does. Futures contracts allow investors to speculate on the price direction of an index, in this case, the VIX.
Buying $UVXY is like buying insurance. If you pick up shares when market volatility — and hence $UVXY’s price — is low, you’ll have protection against a pullback.
Whenever the next market scare comes along, volatility and investor fear will increase, which will in turn cause $UVXY to spike. When that happens, you’ll reap big profits. Those gains will also help offset losses from stocks or bull-call options that you hold.
While $UVXY is a great hedge against volatility, it still comes with risk. These risks are also very different than typical ETFs and stocks.
First, $UVXY is a leveraged ETF. It uses financial derivatives and debt to amplify the returns of its underlying index, the VIX Short-Term Futures. $UVXY is leveraged at 1.5x, which means that it will produce returns that are 1.5 times that of the underlying index.
For example, if the VIX Short-Term Futures Index gains 20%, $UVXY will gain 30%. Of course, this works both ways. If the underlying drops 20%, $UVXY will drop 30%.
Leveraged ETFs provide the opportunity to maximize your gains, but they also multiply losses. Therefore, they are best used to take advantage of short-term market moves. They are rarely suitable for long-term investing.
As such, $UVXY should only be used as a short-term trading tool. NEVER use it as part of a buy-and-hold strategy. This is because $UVXY’s price decreases over time due to a phenomenon called contango. Contango is when the futures price is higher than the spot (current) price.
Moreover, funds like $UVXY do not hold their futures contracts to expiration. Instead, when contracts approach expiry, they roll them. Rolling is the process by which a fund closes out a futures position prior to its expiration month and then purchases an identical futures contract with a later expiration date.
The combination of contango and rolling leads to additional fees, which negatively impact the fund’s performance. Since it is common for VIX futures to be in contango, ETFs like $UVXY lose money over time.
That understandably leads to this question…
The answer to that question goes back to what I mentioned above: $UVXY and similar ETFs are for short-term trading only…NOT buy-and-hold strategies!
While it’s true that $UVXY will lose money in the long run, the price decline is not constant. Take a look at this 3-month price chart from Sept. 2021 to Dec. 2021:
The price moves from the top-left corner of the chart to the bottom-right, which reflects a significant price drop. But…look at all the upward spikes along the way. That is how you profit from $UVXY.
$UVXY’s price jumps can be significant, often leading to 50%-100% gains in just a day or two. When that happens, sell your shares and lock in the profits.
Since $UVXY is usually in a steady decline, it’s best to start by opening a small position and then slowly add to it over time. When I trade $UVXY, I start by committing 1% of my portfolio and then dollar cost average until I’m at a maximum of 5% allocation.
This gradual accumulation of shares accomplishes two things:
- Even if my timing is completely wrong, I will only lose a maximum of 5% of my portfolio. And that will only occur if $UVXY’s price goes to $0 (highly unlikely).
- Acquiring shares at decreasing prices sets me up for a huge profit when volatility spikes.
As I mentioned above, I sell my shares of $UVXY after large price jumps to lock in the profits. After that, I have two choices:
- Wait until market volatility returns to normal, which will cause $UVXY to drop again.
- Buy puts or bear-put spreads of $VIX.
Choice #1 is straightforward. I simply sell when I reach my desired profit and then wait for prices to drop. After that happens, I’ll restart the buying cycle.
But why not profit from both directions? That’s choice #2.
When I see signals that market volatility is peaking, I’ll open a bear-put spread option on $VIX. (Buying a put can also work, but I much prefer spreads). This strategy lets me profit when the VIX index drops.
The most challenging part of this options strategy is picking an expiration date far enough away to give time for the VIX to drop but not so far away that premiums are too high and/or the VIX spikes again.
But what about $UVXY? Can you instead short that ETF?
Theoretically, you can. It’s difficult to get your ordered filled, however, because $UVXY shares are hard to borrow. Your trading platform may even alert you to this.
That’s why my strategy is to buy shares of $UVXY when I expect market volatility and fear to increase and to open bear-put spreads of $VIX when I anticipate volatility to drop. The former gives me a leveraged position without the time pressure of options. The latter is easier to get and also lets me profit when markets stabilize.
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