Inverse volatility ETFs

1. Inverse Volatility ETFs: A Beginner's Guide

Inverse volatility Exchange Traded Funds (ETFs) are financial instruments designed to profit from a *decrease* in market volatility, or, more specifically, a decrease in the implied volatility of the S&P 500 index. They function as the opposite of volatility ETFs, which aim to benefit from increasing volatility. This article will provide a comprehensive overview of inverse volatility ETFs, covering their mechanics, common examples, risks, strategies for utilizing them, and how they differ from other investment vehicles. It is geared towards beginners, so technical jargon will be explained as clearly as possible.

1. 1. Understanding Volatility

Before diving into inverse volatility ETFs, it’s crucial to understand what volatility means in financial markets. Volatility refers to the degree of variation of a trading price series over time. High volatility means the price can change dramatically over a short period, with large swings up and down. Low volatility means the price remains relatively stable.

There are two main types of volatility:

• **Historical Volatility:** This measures how much the price of an asset *has* fluctuated in the past. It's calculated using historical price data.
• **Implied Volatility:** This is derived from the prices of options contracts and represents the market's expectation of future price fluctuations. It's a forward-looking measure. Inverse volatility ETFs primarily track the implied volatility of the S&P 500, specifically the VIX index, often referred to as the "fear gauge."

The VIX (Volatility Index) is a real-time market index representing the market's expectation of 30-day forward-looking volatility. It's calculated from the prices of S&P 500 index options. A high VIX generally indicates increased investor fear and uncertainty, while a low VIX suggests complacency.

1. 1. How Inverse Volatility ETFs Work

Inverse volatility ETFs achieve their inverse exposure through the use of derivatives, primarily futures contracts. They typically *short* VIX futures contracts. "Shorting" means profiting from a *decline* in the price of an asset.

Here’s a simplified explanation:

1. **The ETF buys VIX futures contracts.** These contracts obligate the ETF to buy the VIX at a predetermined price on a future date. 2. **If implied volatility (and therefore VIX futures prices) decreases**, the ETF can sell these contracts back at a lower price, realizing a profit. 3. **The ETF then passes this profit (minus fees and expenses) on to its investors.**

However, it's not quite that simple. The VIX is not directly investable. The VIX futures market is based on a “contango” or “backwardation” structure.

• **Contango:** This occurs when futures prices are *higher* than the spot price of the underlying asset (in this case, the VIX). This is the most common scenario. In contango, the ETF must continually “roll” its expiring futures contracts into more expensive, further-dated contracts, resulting in a gradual erosion of value over time, even if the VIX itself remains relatively stable. This is known as “roll yield” and is a major factor impacting the performance of inverse volatility ETFs. See Futures Contract for more information.
• **Backwardation:** This occurs when futures prices are *lower* than the spot price. This is less common but beneficial for inverse volatility ETFs. In backwardation, the ETF can roll its contracts into cheaper, further-dated contracts, generating a positive roll yield.

1. 1. Common Inverse Volatility ETFs

Several inverse volatility ETFs are available to investors. Here are some of the most popular:

• **ProShares Short VIX Short-Term Futures ETF (SVXY):** This ETF targets short-term VIX futures contracts (typically the front-month and next-month contracts). It's known for its high volatility and significant decay due to contango.
• **ProShares Short VIX Long-Term Futures ETF (UVXY):** This ETF focuses on longer-term VIX futures contracts. While it may be less susceptible to daily fluctuations than SVXY, it still suffers from contango erosion.
• **VelocityShares Short-Term VIX Futures ETF (VXX):** While technically not *inverse*, VXX is often compared to inverse volatility ETFs as it aims to track short-term VIX futures. It’s important to understand its structure, as it's also highly susceptible to contango. Consider learning about Exchange Traded Funds to understand their underlying structure.

• • Important Note:** The performance of these ETFs can vary significantly, and they are *not* suitable for all investors. Their structures and the impact of contango/backwardation are complex.

1. 1. Risks Associated with Inverse Volatility ETFs

Inverse volatility ETFs are inherently risky and are not designed for long-term holding. Here's a breakdown of the key risks:

• **Contango:** As mentioned earlier, contango is the biggest enemy of inverse volatility ETFs. The constant rolling of futures contracts into more expensive ones erodes value over time. This means that even if the VIX stays flat, the ETF can still lose money. Understanding Time Decay is crucial when dealing with these instruments.
• **Volatility Spikes:** The VIX tends to spike dramatically during market corrections or periods of heightened uncertainty. These spikes can cause substantial losses for inverse volatility ETFs, as their short positions are forced to cover at higher prices.
• **Compounding Effects:** The daily resetting and compounding of returns can lead to significant deviations from the expected inverse performance, especially over longer periods. This is a complex concept related to Compound Interest and its inverse application.
• **Leverage:** Some inverse volatility ETFs employ leverage, amplifying both potential gains and losses. This increases the risk considerably.
• **Complexity:** The mechanics of VIX futures and ETF structures are complex, making it difficult for many investors to fully understand the risks involved.
• **Tracking Error:** The ETF may not perfectly track the inverse of the VIX due to factors like fees, expenses, and the complexities of futures contract rolling.

1. 1. Strategies for Utilizing Inverse Volatility ETFs

Despite the risks, inverse volatility ETFs can be used strategically by experienced traders. Here are a few potential strategies:

• **Short-Term Trading:** Inverse volatility ETFs are best suited for short-term trades, capitalizing on periods of expected low volatility. Traders attempt to profit from short-term declines in the VIX.
• **Mean Reversion:** This strategy involves betting that the VIX will revert to its historical average after a spike. Traders buy inverse volatility ETFs after a VIX spike, hoping for a subsequent decline. See Mean Reversion Strategy for details.
• **Pair Trading:** This involves taking opposing positions in a volatility ETF (e.g., VXX) and an inverse volatility ETF (e.g., SVXY), aiming to profit from the convergence of their prices.
• **Hedging:** Inverse volatility ETFs can be used to hedge a long portfolio during periods of expected low volatility, offsetting potential losses if volatility remains low. Learn more about Hedging Strategies.
• **Volatility Arbitrage:** Identifying discrepancies between implied volatility and realized volatility to profit from the differences. This requires advanced knowledge of Statistical Arbitrage.

• • Important Disclaimer:** These strategies are not foolproof and involve significant risk. Thorough research and risk management are essential.

1. 1. Inverse Volatility ETFs vs. Other Investment Vehicles

Here’s a comparison of inverse volatility ETFs with other common investment vehicles:

• **Stocks:** Stocks represent ownership in a company, offering potential for long-term growth but also carrying company-specific risk. Inverse volatility ETFs are based on volatility expectations and are not tied to the performance of individual companies.
• **Bonds:** Bonds represent loans to governments or corporations, offering a fixed income stream but with limited upside potential. Inverse volatility ETFs are much more volatile than bonds.
• **Mutual Funds:** Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. Inverse volatility ETFs are more specialized and carry higher risk than most mutual funds.
• **Options:** Options contracts give the buyer the right, but not the obligation, to buy or sell an asset at a specific price. Inverse volatility ETFs offer a simpler way to express a view on volatility than directly trading options. Explore Options Trading for a deeper understanding.
• **Volatility ETFs (Long VIX):** These ETFs are the opposite of inverse volatility ETFs. They profit from *increases* in volatility. Volatility ETFs provide a counterpoint for portfolio diversification.

1. 1. Technical Analysis and Indicators for Inverse Volatility ETFs

Utilizing technical analysis can help identify potential trading opportunities with inverse volatility ETFs. Here are some relevant indicators and concepts:

• **Moving Averages:** Identify trends and potential support/resistance levels. Moving Average
• **Relative Strength Index (RSI):** Measure the magnitude of recent price changes to evaluate overbought or oversold conditions. RSI Indicator
• **MACD (Moving Average Convergence Divergence):** Identify trend changes and potential buy/sell signals. MACD Indicator
• **Bollinger Bands:** Measure volatility and identify potential price breakouts. Bollinger Bands
• **Volume Analysis:** Confirm the strength of trends and identify potential reversals. Volume Analysis
• **Fibonacci Retracements:** Identify potential support and resistance levels based on Fibonacci ratios. Fibonacci Retracement
• **Support and Resistance Levels:** Identify price levels where buying or selling pressure is likely to emerge. Support and Resistance
• **Trend Lines:** Identify the direction of a trend and potential breakout points. Trend Lines
• **Chart Patterns:** Recognize formations that suggest potential future price movements (e.g., head and shoulders, double tops/bottoms). Chart Patterns
• **Candlestick Patterns:** Analyze individual candlestick formations to gain insights into market sentiment. Candlestick Patterns
• **ATR (Average True Range):** Measures volatility. ATR Indicator
• **ADX (Average Directional Index):** Measures trend strength. ADX Indicator
• **Stochastic Oscillator:** Measures momentum. Stochastic Oscillator
• **Ichimoku Cloud:** A comprehensive indicator providing support/resistance, trend direction, and momentum signals. Ichimoku Cloud
• **Elliot Wave Theory:** Analyzing price movements based on repeating wave patterns. Elliot Wave Theory
• **Harmonic Patterns:** Identifying specific geometric price patterns. Harmonic Patterns
• **Market Sentiment Indicators:** Gauging the overall mood of investors. Market Sentiment
• **Correlation Analysis:** Analyze the relationship between inverse volatility ETFs and other assets. Correlation
• **Seasonal Trends:** Identifying recurring patterns based on time of year. Seasonal Trends
• **Gap Analysis:** Analyzing price gaps to identify potential trading opportunities. Gap Analysis
• **Pivot Points:** Calculating support and resistance levels based on previous day's price action. Pivot Points
• **Donchian Channels:** Identifying breakouts based on highest and lowest prices over a specified period. Donchian Channels

1. 1. Conclusion

Inverse volatility ETFs are complex financial instruments that offer the potential for profit, but also carry significant risk. They are best suited for experienced traders who understand the nuances of VIX futures, contango, and the inherent limitations of these ETFs. Beginners should exercise extreme caution and thoroughly research the product before investing. Remember that inverse volatility ETFs are *not* designed for long-term holding, and their performance can be unpredictable. Always practice proper risk management and consider your own investment objectives and risk tolerance before making any investment decisions. Further research into Risk Management is highly recommended.

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners