The CBOE Volatility Index (VIX), also known as the fear index, measures stock market volatility based on premiums paid for option on the S&P 500 index. It is a complex calculation, but what traders need to know is that VIX rises when prices are falling rapidly, because options premiums tend to rise just as rapidly. Gains in option premiums lead to higher values of VIX. When markets are rising steadily or moving sideways in a consolidation, options premiums drop, as does the value of VIX.

In some ways, volatility seems like it should be more tradable than price. In Bollinger on Bollinger Bands, analyst John Bollinger observed that volatility is cyclical and high volatility begets low, and low volatility begets high.

We are now at a point of low volatility, which means we will inevitably see a return to high volatility at some time in the future. Recently, VIX fell to its lowest level since the summer of 2007, leading many traders to wonder what would happen if they bought low volatility.

From the chart below, it looks like they would eventually be rewarded with profits, because after reaching low levels, VIX does rise.

In reality, trading VIX is not so straightforward. VIX is a wasting asset based on options and traded with derivatives that have expiration dates. Many derivatives expire worthless and that creates a downward bias in the expected returns.

Trading VIX can be done with exchange-traded notes (ETNs), which are like exchange-traded funds (ETFs) except that ETNs hold derivatives rather than stocks. Companies that sponsor ETNs face higher expenses than they do with ETFs, and these costs lower the returns of investors. These factors mean that the ETNs will not precisely track VIX. To make some sense of these ideas, lets look at some test results.

We want to buy VIX when it is low and sell when it is high. Testing shows this is possible. Rather than defining low in absolute terms (a rule like, buy when VIX is less than 15), we will use a relative definition of low. We will want to buy VIX when it falls into the lower 20% of its Bollinger Bands. This uses the Bollinger %B indicator and buys when %B is less than 20.

Exiting at any time frame from one day to six weeks after buying VIX would be profitable with the average winning trade being more than twice as large as the average loss. On average, about 60% of the trades would be winners. Unfortunately, it is impossible to trade the VIX directly.

When we apply that simple strategy to VIX futures, the results are large losses for all holding periods. It is the same with ETNs on VIX, including iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX ), iPath S&P 500 VIX Medium-Term Futures ETN (NYSE: VXZ ), VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX ) and ProShares Ultra VIX Short-Term Futures ETF (NYSE: UVXY ) .

One problems traders face is that VIX spikes higher and rapidly falls back down. It is entirely possible that we are missing the trading gains by exiting only after a specified time. We can instead exit after a price move of specific size occurs. Again, this works well on the VIX, but not as well on the vehicles used to trade the VIX.

With this revised strategy, we buy when VIX is low and sell when it reaches a profit target or a stop-loss. For testing, we can use a 10% profit target and a 3% stop-loss. This is a very profitable strategy on the VIX itself with about 80% winners and profits that are obviously more than three times larger than losses. When it was tested against the ETNs, however, only one was profitable: UVXY.

The exact way each ETN is structured is a trade secret of the sponsors, but in testing, UVXY seems to be the best proxy for VIX and is our preferred trading vehicle.

Right now, VIX is very low and many traders will be tempted to trade it. We recommend buying UVXY and trading with a profit target and stop-loss.

Normally, we also recommend a way to trade with options, but in the case of UVXY, options are expensive and it would be difficult to profit with a simple buy strategy. Part of successful trading is knowing when not to trade, and this is one of those times for VIX-related options strategies.

Recommended Trade Setup:

— Buy UVXY at the market price

— Set stop-loss 3% below entry price

— Set profit target 10% above entry price

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