Piles of Cash When Markets Drop
A lesson in trading volatility so you smile when markets are falling.
This service is for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. These are my opinions and observations only. I am not a financial advisor.
I had a big pile of cash sitting in my account staring at me. Markets were dropping and stocks were going on sale.
This is one of the best feelings a trader can have.
There was only half as much capital in my account just a few days earlier but I made a trade that I knew could put me in this powerful position.
And that is what this week’s newsletter is all about. Trading to create cash in your account at the exact time everyone else is selling.
How does this work? There’s no magic to it. It just requires a basic understanding of the VIX and how to trade it.
Before we get to the good stuff, a quick thank you to the hundreds of subscribers that read A Trader’s Education every week. I appreciate your support and engagement. Keep the questions and comments coming!
Also, if you enjoy the newsletter but are looking for more charts, more trading levels, and more trading ideas I have good news. I am building something great!
My notes, preparation, and every single chart I analyze is in the process of being transferred to discord so everyone can access all of it. There will be a modest monthly fee but I will keep it as low as I can so as many as possible can enjoy it!
Here’s a sneak preview.
Let me know what you think! Drop a comment or DM me on Twitter @tradernatehere and I will take every suggestion into consideration. I’m excited to launch this for you!
Trading the VIX - Building Cash When Markets Drop
Just like with any trade, it is important to pick the rights spots and not overtrade the VIX. There is a real tendency to keep making trades in the VIX after an initial success. This isn’t wise and we’ll take a look at why.
First, when do you want to buy volatility?
Good news, it’s no different than when you want to buy a stock. You want to buy low.
What I have found this year is specifically, you want to buy new lows.
This chart of the VIX shows that every time a new low is made there is a quick rebound. This has been a noticeable pattern since the market started its move higher back in January.
Also note, the bounce happens quickly but doesn’t always hold up for long. This is important and where many go wrong.
The VIX is no place to stick around. Get in and get out with your profits. That’s how I prefer to trade volatility because overall the VIX is a sideways moving instrument.
Volatility doesn’t increase over long periods of time like the stock market does. Instead, it trades in a range and your job is to buy the bottom of the range.
This is easier said than done because it can often seem like the bottom of the range is hit only to see the VIX trade sideways or lower for a while after.
To avoid this trap, I have been waiting for new lows to form and pick those spots for buying the VIX. The chart above shows the consistent bounce that occurs when a new low has been hit.
This past week we had the added bonus of knowing the FOMC was making yet another rate decision and we had big names like AMD and AAPL reporting earnings.
These type of events tend to drive up volatility as we head into them and that is where you take your profits.
To get these kind of returns you cannot be greedy and you cannot overthink the trade. Trading volatility can be…volatile. As always, I recommend taking profits when they’re presented. Avoid the temptation to let it ride a little longer.
The VIX spikes and when it does it tends to make decent size moves. These big moves are often followed by a quick retreat.
The importance of selling before this retreat cannot be overstated. In fact, when trading options it is often the case that the initial surge is the best price you will get.
Why does this happen?
As time passes, options lose some of their “time value” which makes the option less valuable over time, all other things held constant.
This declining value driven by approaching the expiration date of the option means the stock has to rise even further than it did previously for the option to regain its prior high value.
Here’s an example using the VIX options I traded successfully this week.
Once the new low had been established it was time to take a position with VIX calls. I expected a quick move and we got one the very next day.
The big move up gave the opportunity to nearly double my position earning over 96% gains in a single day.
And as mentioned, the VIX quickly retreated and the option price dropped back off significantly. That is a lot of profit to give up on the hope for more after such a nice gain.
This is a common mistake when trading volatility. You do not “hang on to winners” like you might with a stock that is running.
Looking back at the first chart, what do you notice? A nearly immediate reversal every time volatility spikes.
Here’s a look going back years and you’ll see the same thing.
Another common error made when trading volatility is the expectation that a big event like earnings or the FOMC rate decisions will drive the VIX higher.
Volatility is driven by uncertainty. When we get the information there is less uncertainty and volatility often declines.
This is precisely why I take profits heading into events instead of waiting until afterwards. Why give up nearly 100% gains when you don’t need to?
At the very least, I recommend trimming positions that have moved up ahead of a big event. You can make the decision to leave a little on the table but do not make the mistake of risking everything for a few more percentage points.
The key takeaways for trading the VIX are:
Focus on buying the low - new lows have worked very well lately
Utilize at-the-money calls or just slightly out-of-the-money
Choose an expiration date that allows enough time for the trade to develop
Take profits on the initial big gains, don’t hesitate
If you follow these rules, the next time volatility is at a low and decides to uncoil you will be armed with a new pile of cash at just the right time.
Twitter Spaces - Chart Reviews, Trading Strategies
Friendly Reminder and big thank you to everyone that tunes in!
Every weekend I host a Twitter Space with Shaun Clarke - @ShaunClarke_ and Kaye @InvestKaye reviewing dozens of charts and talking strategies for the upcoming week.
It is a great way to sharpen your chart analyzing skills while hearing about what we are each looking at for possible trades.
Link to this week’s Twitter Space: Sunday Trading Prep
I hope you find this information useful each and every week.
Thank you again for reading and an extra special thank you to those that are pledging $8 every month. It may seem small, but it means a lot!
Have a great week!
Nate