This is a very short educational post that will cover the most efficient way to trade the long side of volatility instruments.
As you might have noticed already, implied volatility has a directional connection with SPX. More exactly it has an inverse correlation with price level in SPX. In other words, when SPX falls implied volatility goes up and vice versa. For those of you that are looking into playing a potential SPX fall with volatility instruments (VXX, VIX futures, VIX options etc) here is my recommendation based on the goal of the play:
- If the goal is to scalp a few bps (basis points) of volatility ( 1 bps = 1/100 of 1 vol) to 1 or 2 full vols, the best trade (perhaps the only possible trade) is to go long outright the front month VIX future. There is nothing else that can beat that trade as VXX is highly inefficient to the long side (and worse yet, it decays too fast).
- If the goal is to trade the end of the world scenario, then nothing beats VIX options, just go and buy OTM vertical call spreads (don’t buy single calls as they are always expensive). The magical strike is usually always at 19,20 or 21 as those are the values that VIX always reverts too just before the end of the world fall.
The most important recommendation here. Never, ever, under no circumstances short a volatility instrument outright (naked, unhedged). Shorting volatility with leveraged instruments is the easiest way to go broke, no matter how tight the stop is in a black swan event the market will go over your stop like butter and with zero liquidity, meaning no execution of your closing trade. You will be most likely owning quite a chunk of money to your broker next time you know.