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Sept. 27, 2016, 2:00 p.m. EDT

A misunderstood VIX trade that comes with built-in safety cushion

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About Simon Maierhofer

Simon Maierhofer is the founder of iSPYETF and publisher of the Profit Radar Report. Investor’s Business Daily once wrote that: “Simon says and the market is playing along.” Simon analyzes technicals, proprietary supply and demand data, sentiment and seasonality to spot low-risk or high-probability ETF setups. He has been featured on: CNBC, FOX News, the Wall Street Journal, and many other financial-news outlets.

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The CBOE Volatility Index (VIX) is one of the most popular and most over-analyzed index/indicators. There are many ways to (over) use the VIX, but the best way to actually trade the VIX (and make money) is also the most misunderstood. Perhaps because the premise is a bit complicated.

Simplified complexity

Here is a simplified explanation of the most consistently profitable VIX trade. For more details refer to the referenced column links further down.

The VIX itself is not a tradable index, just like the S&P 500 /zigman2/quotes/210599714/realtime SPX -1.18%  is not a tradable index. But there are dozens of tradable S&P 500 “replica,” funds (like the SPY) that mirror the S&P 500 and make it tradable. The same is true for the VIX. However, mirroring the performance of the VIX is not as easy as duplicating the performance of the S&P 500 or other equities.

Fund providers have to use more sophisticated instruments like futures to mirror the VIX. The problem is that futures come with a time premium. This time premium is called contango. A detailed explanation of contango is available here: “ VIX contango explained .”

The VIX contango is currently around 10%. That's the price difference between today's VIX and next month's VIX. This means that volatility ETPs, like the iPath S&P 500 VIX Short-term Futures /zigman2/quotes/202248173/composite VXX +7.23% , have to go up about 10% over the next month just to make up for contango.

Reversing the cost of contango into income

Fortunately, it is possible to reverse the contango headwind into a tailwind (turn the cost of contango into income). This can be done via ETPs like the VelocityShares Daily Inverse VIX Short-term .

On average, XIV gains about 0.24% a day mainly due to converting contango from cost to income. How this works and why it comes out to 0.24%/day is explained here: “ The Spectacular VIX Tailwind Trade .”

The chart below plots contango against the VIX and the S&P 500. This comparison shows a number of factors:

  1. Contango extremes tend to coincide with VIX and S&P 500 highs/lows (see most recent contango low – dashed green line)

  2. Higher contango tends to benefit XIV

Timing the tailwind trade

The best time to buy XIV is when the VIX spikes, but remains below 20. This happened on Sept. 9, when the VIX spiked 40%, but closed below 20. This was a perfect setup for the Profit Radar Report's favorite trade.

The Sept. 11 Profit Radar Report recommended buying XIV at 33.55 (this position was closed on Sept. 22 at 38.40 for a 14% gain). In fact, we've never lost money on this XIV trade. This doesn't mean it's impossible to lose money trading XIV. Timing is still very important, but the reverse contango tailwind provides a safety cushion unique in the business.

The VIX and the S&P 500

There almost always is an inverse relationship between the VIX and the S&P 500. This means we can use the VIX as an indicator for the S&P and vice versa. When both indexes send the same message, we get a higher-probability signal.

The very best seasonal turning point for the VIX is approaching soon. It will be interesting to see if our S&P 500 analysis confirms the upcoming seasonal fat patch VIX-(XIV) trade.

Early telltale signs look promising. Here is a look at the latest S&P 500 forecast, the next best setup, and what it means for the VIX.
S&P 500 Forecast

-53.96 -1.18%
Volume: 3.04B
Dec. 1, 2021 5:04p
US : U.S.: Cboe BZX
$ 27.30
+1.84 +7.23%
Volume: 70.31M
Dec. 1, 2021 4:00p

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