Trading Volatility ETPs: Obey Thy Stops


Last week I shared two simple strategies for trading volatility ETPs like VXX and XIV (read strategy #1 and strategy #2).

As I hope I made clear enough, these strategies were meant to be illustrative and are NOT ready for actual trading.

The most important element both strategies were missing was protective stops.

The nature of these ETPs means that your trade is less likely to move against you in tiny increments (like a dripping faucet) assuming that you stay on the right side of the VIX futures term-structure.

But at some point you will be on the wrong side of the trade when the VIX jumps (which overshadows the effect of the term-structure) and your position will move against you very quickly.

That’s especially true when you’re short volatility (ex. long XIV) because the VIX is much more prone to spiking up than down.

This “spiky” nature of the volatility ETPs means that protective stops are even more important than with most conventional assets.

I considered different ways to illustrate that point statistically, but I think a simple chart of XIV back to 2004 makes a better case than a number ever could. Note all of the crashes over just the last 8 years.

Happy Trading,

Geek note: read more about how I produced XIV returns back to 2004.

. . . . .

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14 Responses to “Trading Volatility ETPs: Obey Thy Stops”

  1. 1 Andrew

    Suppose there is an overnight event and VXX opens higher by 100%. Then stops wouldn’t help because XIV would open at zero. The only safe way to play short volatility is with options…

    • 2 MarketSci

      RE to Andrew: your point is well taken and I appreciate the thoughts, but I disagree with the idea that that should somehow preclude investors from using these products.

      By an extension of that logic, ALL stocks, ETFs, mutual funds, etc. are inappopriate investments b/c they all carry overnight risk. Yes, larger losses are more likely with vol. ETPs because they’re more volatile, but the assumption you have to make is that a rational investor recognizes that fact and allocates a smaller portion of their portfolio because of that inherent risk/volatility.


  2. 3 Andrew

    I had similar concerns but, ultimately, I just lowered my position size. I trade XIV/VXX with 10-20% of my account equity. I can sleep with that overnight Black Swan risk.
    Also, consider your real trading costs/b/a spread etc. in the options arena – the underlying is cheaper imo.
    Another Andrew

  3. Your few posts had me going and I researched this term structure/VIX concept further but directly in the futures space (where I believe the exact same phenomenons exist – indeed ETPs are just wrappers of futures..). The idea being that futures would allow to pick different horizons on the term structure curve – which is not flat.

    Anyway, the funny thing, in relation to this post, is that the CBOE will not accept ANY stop orders at ANY time for VIX futures:

    “Stop Orders for the VIX futures contract will not be accepted by the Exchange at any time. Any Stop Orders for the VIX futures contract received by the Exchange at any time will be automatically rejected.”

    (stop-limit orders are however accepted)

  4. 5 xls5929

    Do you really gain anything from stops in a strategy like this? A nosedive isn’t predictable, so once it hits, the damage is done. A slow bleeding droop or a series of smaller droops are also unpredictable and once they hit, the damage is done.

    Trying to protect this type of strategy with stops simply kills off some of the upswing by closing positions before they’ve had a chance to run. The tighter the stop, the more upswing is killed off.

    As described above, one way out is to simply risk a small enough part of your capital so you can survive.

    • 6 MarketSci

      Hello xls5929: when you’re talking about equity plays, especially ones that are based on OB/OS (ex. buying stocks on dips), I think that’s often true. Better to play small rather than use stops.

      But IMHO these products are different because when volatility spikes up causing the term-structure to shift, moves in the ETP become magnified. You’re getting hit twice: once from the move in the VIX and again from the backwardation. As the graph above shows, during crises, things get out of control pretty quickly. I don’t think “riding it out” makes sense here like it might with an straight equity play.

      Just my $0.02.


      • 7 xls5929


        I think I might have figured out an important difference in our methods. In your Strategy #2 post, you mention your trading frequency as “…less than 1 trade per week….”. My method is based on daily trades, which is why the daily Open/Hi/Lo is also important. I think I can see how a stop strategy at your frequency may not be as punishing as it is at a daily frequency. I’ll have to think about that some more.


      • 8 MarketSci

        Hello xls5929 – there’s no “reply” link once comments get 3 levels deep.

        I think reducing allocation is a perfectly fine approach. You’re just limiting exposure (and potential returns).

        Just one additional thought: there is limited data to consider (b/c of how new these products are) and backtests are always by their nature curve fit.

        So if I could create a strategy that wasn’t significantly negatively impacted by stop losses (i.e. if the backtest was just a little worse), I would still use them because that limited data and curve fitting guarantees that “next time” will be very different than “this time”.

        In my case, I use multiple stop losses and scale down positions as positions move against me. That way if “next time” is like “last time” and the VIX bounces back, the negative impact of those stop losses is limited. But if “next time” isn’t like “last time” damage to the portfolio is limited.

        There’s no right answer here…just my $0.02.


      • 9 xls5929

        You might want to try various stop schemes and see what happens. I’ve been playing with a strategy similar to what you’ve described, and so far, any stop scheme reduces the overall profitability with a minimal effect on drawdowns. In fact, the reduced-profits makes the overall method more risky.

      • 10 MarketSci

        Hello xls5929 – my assessment was based on have already done a lot of analysis of the issue for my own trading.

        Out of curiousity – how far back are you backtesting? If you’re only looking at the VXX since launch in 2009, you’re going to miss some very volatile moments in recent history. You can go all the way back to 03/2004 using VIX futures to simulate VXX (and/or back to 2006 using Bloomberg data).


      • 11 xls5929


        I couldn’t find a “reply” selection under your post, so I put it here.

        I estimated the data from the futures data, back to March 2004 (I haven’t checked out your Excel files, but I will when I can…..thanks by the way) . However, during my estimating process, I discovered how iffy the calculation can be. When I tried to extend that calculation to estimate Open/Hi/Lo data (for stops calcs), I was even more uncomfortable. My point is, I trust the actual Open/Hi/Lo/Close data far more than the estimated data. I consistently keep that in mind when I’m testing any type of strategy.

        Anyway, to keep things simple, I’ll use your second graph (cumulative profits) in the Strategy #2 post. You stated that the return was around 53%/yr and the max drawdown was 33%. Correct me if I’m wrong, but isn’t that without stops. My version of a similar strategy may have a different return and drawdown, but it also is without stops. When I try various stops schemes, the return drops while the max drawdown is reduced only a small amount. I am aware of the possibility of another Flash Crash or 1987-nosedive where stops may or may not work anyway, so my current solution is to back the percent-of-capital down to an acceptable level, just in case.

        Bill (probably easier to keep track if you continue to use xls5929)

  5. 12 brekekex


    As an alternative (or supplement) to stops I think it can make sense to fully or partially hedge a long XIV position with a long VXZ position. Not a perfect solution, as when XIV starts to fall, VXZ will increase with a lower percentage. And of course, the VXZ position slowly reduces the total gains on XIV. On the other hand, the pair responds similarly to overnight and intraday moves, so overnight gaps are less of an issue.


    • 13 MarketSci

      Hello Andras – thanks for the smart thoughts – sort of analagous to shifting to a position in XVIX or XVZ (with more weight on the short front month position). Not a trade I would want on all the time, but certainly would make sense in times of market stress. michael

  1. 1 Monday links: upsides, downsides | Abnormal Returns

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