Volatility securities such as the TVIX become more valuable when market swings increase, making them an attractive choice for traders looking to protect gains in equities. The TVIX is designed to generate twice the daily return of a gauge tracking futures on the Chicago Board Options Exchange Volatility Index. The VIX moves in the opposite direction of the Standard & Poor’s 500 Index about 80 percent of the time.
Volatility in stock markets has been particularly low over the last two years, not least because investors concluded quantitative easing represented justification for one-way bets on the rise in asset prices. With substantial paper profits fund managers have a vested interest in attempting to hold on to as much of the gain as possible, so the allure of volatility ETFs becomes more appealing as short-term overbought conditions develop.
The VIX Index is also incorporated into the calculation of position sizing used by leveraged and automated traders. When volatility is low, a larger position can be justified because the potential drawdown in a reaction is deemed to be shallow. However when volatility rises, traders are forced to cut position sizes in order to manage risk. The speed of the decline in January exemplified this tendency.
Historically, spikes in the VIX have been much better buying opportunities than depressed levels have been selling opportunities. If we look at the above overlay of the S&P 500 with the VIX, we can see that as the pace of the advance has picked up, rallies in the VIX have been considered buying opportunities at progressively lower levels. Since volatility has been so low for so long, the 2-year average volatility will also be low. This means that when thinks about standard deviations from the mean, the levels programs will be incorporating are tight relative to what we know from market history is possible.
A break above 20 on the VIX is likely to coincide with a long awaited reaction of greater than 10% for the wider market.
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