How to Day Trade Volatility ETFs

There are times when day trading volatility exchange-traded funds (ETFs) is very attractive, and times when volatility ETFs should be left alone. A volatility ETF typically moves inversely to major market indices, such as the S&P 500. When the S&P 500 is rising volatility ETFs will typically decline. When the S&P 500 is falling, volatility ETFs will rise. Just like the market indexes, trends also develop in the volatility ETFs. A strong uptrend in the S&P 500 means a downtrend in volatility ETFs, and vice versa. Day traders can exploit the big moves that occur in volatility ETFs at major market reversal points, as well as when the major indexes are in a strong decline. 

​Commonly referred to as volatility ETFs, there are also volatility ETNs. An ETF is an exchange-traded fund which holds underlying assets in that fund. An ETN is an exchange traded note, and does not hold any assets. ETNs don't have the tracking errors that ETFs may be prone to because ETNs only track an index. ETFs on the other hand, invest in assets which track an index. This extra step can create performance discrepancies between the ETF and the index it is supposed to represent.

ETFs and ETNs are both acceptable for day trading volatility, as long as the ETF or ETN being traded have lots of liquidity. 

(Need a brush-up on indicators? See "The Four Most Important Indicators in Trend Trading.")

There are a number of volatility ETFs to choose from, including inverse volatility ETFs. An inverse volatility ETF will move in the same direction as the major indexes (the opposite/inverse direction of traditional volatility ETF). When day trading, a simplistic ETF/ETN with high volume is usually the best choice. The iPath S&P 500 VIX Short Term Futures ETN (VXX) is the largest and most liquid in the volatility ETF/ETN universe. 

The ETN sees average volume of more than 15 million shares per day, typically, but spikes to more than 70 million when the S&P 500 sees a significant decline and traders pile into VXX pushing it higher.

​VXX usually sees explosive moves when the S&P 500 declines. The moves in VXX typically far exceed the movement seen in the S&P 500. For example. A 5% drop in the S&P 500 may result in a 15% gain in VXX. Therefore, trading VXX provides more profit potential than simply shorting the S&P 500 SPDR ETF (SPY). Since VXX has a tendency to "overshoot" on declines in the S&P 500, when the S&P 500 rallies again VXX typically sells off in dramatic fashion. 

Day traders have two ways to profit;

• Buy VXX when the S&P 500 is declining.
• Short VXX following a price spike once the S&P 500 begins to rally higher again and VXX is falling. 

Depending on the size of the trend in the S&P 500, favorable trading conditions in VXX can last for several days to several months. The chart below shows a short-term decline and reversal in the S&P 500 and the corresponding rally and selloff in VXX.

The charts show VXX has a tendency to overshoot. It t rallied 105% based on a 11.84% decline in the S&P 500. It then fell 31.6% when the S&P 500 bounced 10% off the low. Such are the times day traders will want to be trading in VXX.

When the S&P 500 is in a very quiet uptrend with little downside movement, VXX will decline slowly and is not ideal for day trading. The big opportunities come during, and in the aftermath of, a several percentage point decline or more in the S&P 500.

Volatility ETFs, such as VXX, will quite often "lead" the S&P 500. When this occurs, it lets you know which side of the trade you want to be on. VXX can be used to foreshadow moves in the S&P 500, which can aid in day trading stocks or S&P 500 futures even when there isn't substantial volatility in the S&P 500.

The chart above provided several clues that the S&P 500 would move higher. VXX was weaker in the morning, moving lower overall even when S&P 500 made a lower low. Then, VXX broke its major support level, indicating the S&P 500 eventually break through its resistance level. It did about half an hour later. VXX won't always lead the S&P 500. Sometimes the S&P 500 will lead, which can also provide us with clues for day trading VXX, as shown in the example below.

The biggest intraday opportunities occur in VXX when there is a significant drop (and/or subsequent rally) in the S&P 500. During such times, the following entry and stop can be used to extract profit from the volatility ETN.

So how do we actually day trade the volatility ETF? First we watch for signs of overall direction. We can do this by looking at the trends in both VXX and the S&P 500, but mostly we also want to compare the two.

At 10:43 the S&P 500 has just made a lower low, and then starts to rally. At that same time, VXX is well below its high and is forming a sideways channel. The S&P 500 continues to rally. A day trader should now be piecing together that VXX is weak (lower low) and that if the S&P 500 is rallying VXX is likely to start dropping soon. 

Wait for a trade trigger. This is an event that actually tells you the price is starting to drop. In this case, VXX is moving in a small consolidation above $33.38. If the price drops below $33.38 the consolidation will be broken, and given the other pieces of evidence a short trade can be taken. 

If going short, place a stop loss $0.02 above the most recent high that occurred just prior to entry. If going long, place a stop loss $0.02 below the most recent low that occurred just prior to entry.

Manually exit trades if you notice the overall trend in the market shifting against you. If you are short, a higher swing low or higher swing high indicates a potential trend shift. If you are long, a lower swing low or lower swing high indicates a potential trend shift. 

Alternatively, set a target that is a multiple of risk. If your risk on a trade is $0.14 per share, aim to take profit at two times your risk, or $0.28.

For example, the short trade above was initiated at $33.37 with a stop loss at $33.51. The distance between the entry and stop loss is $0.14. Therefore, aim to make at least $0.28 on the trade (two times risk) by placing the target $0.28 below entry at $33.09. 

This multiple is adjustable based on volatility. In very strong trends you may be able to make a profit that is three or four times as large as your risk. 

The same method applies when VXX is strong and S&P 500 is weak. VXX will be moving higher; wait for a pullback and a pause/consolidation. When the price breaks above the top of the consolidation at the bottom of the pullback (what we are assuming is the bottom) enter a long position. Place a stop loss just below the low of the pullback.

If the volatility ETN isn't moving enough to easily produce gains which are twice as much as your risk, avoid trading it until volatility increases.

Volatility ETFs and ETNs usually have larger price swings than the S&P 500, making them ideal for day trading. The greatest opportunities in terms of percentage price moves come during and shortly after the S&P 500 has significant declines. A volatility ETN, such as the S&P 500 VIX (VXX) may even foreshadow what the S&P 500 is going to do. When VXX is relatively weak it shows the S&P 500 is likely to be strong. Either go short VXX or long the S&P 500 SPDR. When VXX is relatively strong it shows the S&P 500 is likely to be weak. Either go long VXX or short the S&P 500 SPDR.

No method works all the time, which is why stop loss orders are used to limit risk. Profits should be larger than losses. This way even if only half the trades are winners (profit target is reached), the strategy is still profitable. If you can't reasonably expect to make a profit at least two times  your risk, based on that day's volatility, then don't trade this strategy.