# The birth of a strategy pt. 1 – what is this volatility and where can I buy it?

Continuing from the last post and the overwhelming response (thanks bitfool), the “Birth of a Strategy” series will focus on developing a strategy based on volatility related products (ETFs and ETNS).

As it is not as of a hot topic like in 2014/early 2015 anymore, in this first part of the series we will take a look at a high-level summary of what volatility in this context even is, how it is determined, how it can be traded (which products) and so on. This will serve as a memory refresher for people who haven’t dabbled in volatility trading recently (like myself) and as an introduction for people completely new to it.

* I do understand that all of this information is available in one form or another on many different websites/blogs/etc. What I am trying to detail here is the level of knowledge you should obtain about what you trade (not only related to volatility but in general).

So let’s get into it.

When thinking about volatility in the stock market, one abbreviation usually comes to mind first: the VIX. But what is it exactly, how is it determined and why does it matter for us?

The CBOE Volatility Index, or VIX, is a measure of the implied volatility of options on the S&P500 stock market index. It is being published by the Chicago Board Options Exchange since 1993 (when it was still based on the S&P100). It measures the annualized 30-day expected volatility of the S&P500 Index and does so through the following equation:

$\sigma^{2} = \frac{2}{T} \sum\limits_{i}\frac{\Delta K_{i}}{K_{i}^{2}} e^{RT} Q(K_{i}) - \frac{1}{T} \lbrack \frac{F}{K_{0}}-1 \rbrack^{2}$

$VIX = \sigma * 100$

Even though this formula looks slightly complicated (its details are explained in the VIX white paper here), what it does in simplified form is calculate the expected volatility of the S&P by averaging the weighted prices of out-of-the-money puts and calls. So why is this VIX important for us? It is not even a tradable instrument!

Apart from being _always_ mentioned in the media when it comes to stock market volatility, all of the products that we will cover in this series are related to it for the simple reason that they provide the easiest way for retail traders to trade volatility. I also imagine that the majority of us private traders uses VIX-related products and not options to implement volatility strategies but I could be wrong in that regard.

Let’s take a look how the VIX has developed since 2000 and how it compares to the S&P500.

The first of the two main takeaways is that the VIX looks pretty much mean-reverting. Indeed, if we could trade it (sadly we can’t) we could easily make a fortune. The second one is that it seems inversely correlated to the S&P which is in line with the very generalized saying that usually the market goes up when volatility is low and vice versa.

Ok after all this looks-good-can’t-trade talk, what can we trade? VIX futures and options.

In 2004, the CBOE introduced monthly futures on the VIX (weekly futures followed in 2015), which are contracts on the forward 30-day implied volatility (e.g. the current front month VIX future expiring on the 18th of July is a contract on the 30-day implied volatility, or the VIX, on the expiration date). These futures offer a great way to trade volatility. However, as not everyone can trade futures and the initial margin is “quite high” (currently around \$ 6.200) and might be too much for a small volatility position in a diversified portfolio, they will not be our products of choice. They will play a major role in the potential strategies though (more on that later).

Similar to VIX futures, the CBOE introduced options on the VIX (monthly in 2006, weekly in 2015) and they provide similar exposure as the futures. We will also not deal with them in this series as to trade them it would be highly recommended that you have quite some experience in trading regular equity options as well as a solid understanding of trading volatility in general (which we will develop throughout these posts, hopefully).

Now we get to the interesting stuff, ETPs (Exchange Traded Products) with a connection to the VIX. These are the ones we will ultimately consider for our strategy. We will take a look at two products that offer long exposure on volatility and two that offer short exposure. The first one is the VXX which is the iPath S&P500 VIX Short-Term Futures ETN. What it does is keep a mix of the current front month future and the second month future in such a way that the weighted average of the expiries is one month. This means it rebalances daily, selling a percentage of the current position in the front month future and buying the second month future with the proceeds. In similar spirit, the VXZ (iPath S&P500 VIX Mid-Term Futures ETN), does the same but keeps a weighted average expiry of 6 months by holding the fourth, fifth, sixth and seventh month VIX futures.

Their respective counterparts for the short exposure are the XIV (VelocityShares Daily Inverse VIX Short-Term ETN) and ZIV (VelocityShares Daily Inverse VIX Medium-Term ETN). These four products will form the basis of our investment universe throughout this series.

After this lengthy introduction (we have only scratched the surface, really!), the plan for the next installment is taking a much closer look at the VIX Futures and our ETPs and see how we can potentially obtain some serious returns!

I would also like to encourage you again to participate in one way or another, may it be through criticism, advice, questions, etc through the comments!

Until next time,

QUANTBEAR