Wall Street investors tend to get very nervous during times of heightened volatility such as the 2008 financial crisis.
That’s why some of them look toward the CBOE volatility index in an attempt to get some downside protection during times or market turbulence.
What is the VIX?
Basically, the VIX index behaves like this: when the S&P is down for the day, the index tends to go up. When the markets up, the index tends to go down.
The VIX is also often referred to as Wall Street’s “fear index” or “fear gauge.” It is used by many hedge fund managers, professional investors, analysts and individual traders to predict how volatile the stock market is likely to be in the near future.
According to the Chicago Board Options Exchange (CBOE), the concept of the VIX Index was developed by Dr. Robert Whaley in 1993. Whaley is a regular contributor to Marketplace, The New York Times, The Wall Street Journal, and other financial news organizations on topics of market volatility.
It is important to note, however, that while Whaley developed the concept of the VIX Index, volatility indices were first proposed by researchers Dan Galai and Menachem Brenner in 1989.
How is VIX calculated?
Although the calculation of the VIX is a little complicated, you can refer to this white paper produced by the Chicago Board Options Exchange to understand the details.
As previously mentioned, the intent of the VIX is to capture 30-day expected volatility using SPX index option prices. To accomplish this, the CBOE uses two different expirations and calculates a weighted average.
They use the two expirations that have less than 37 days and greater than 23 days to expiration in order to zero-in on the 30-day timeframe.
In order to ensure liquidity, the calculation takes into account the options on S&P 500. It provides the indispensable link to create tradable products to arbitrage and hedge OTC volatility derivatives.
VIX is also calculated directly from option prices in an independent model way for transparency purposes.
How to trade the VIX
Trading with the VIX involves buying products that track the volatility index. More than 30 trading products have been developed since VIX’s launch to allow traders bet on its levels.
Those levels have gone down drastically since hitting an intraday record high of 89 during the credit crisis a decade ago. In November 2017, the VIX bottomed to a historic low of 9.14. Today, VIX is hovering at about 16. The higher the VIX number, the more volatile the stock market and vice versa.
How to trade VIX futures
Investors can’t own the VIX itself: they can only trade instruments that track the index. Several options are available to trade Wall Street’s so-called “fear gauge.”
Two such options are the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ).
- iPath S&P 500 VIX Short-Term Futures ETN (VXX)
One of the simplest ways is to trade the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This product provides exposure to volatility that sees truly impressive average volume of roughly 36.7 million shares per day.
It provides investors with exposure to a daily rolling long position in the first- and second-month futures contracts on the VIX. Therefore, when the market is insecure and volatility increases, VXX rises in value.
- iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)
The iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) tracks the S&P 500 VIX Medium-Term Futures Total Return Index. VXZ holds rolling long positions in the fourth, fifth, sixth and seventh month VIX futures traded on the Chicago Mercantile Exchange (CME).
The futures are also continually rolled to longer dated contracts from shorter dated contracts throughout the course of the month.
Risks with trading the VIX
- The “contango” trap
The VIX futures market is said to be in a state of contango – that is, when the current price is lower than the future price. For instance, if a one-month VIX futures contract is trading at 15, and the VIX is at 12 today, the VIX futures market is in contango.
This situation is a problem because you are essentially buying high and selling low. Thus dissolving the value of your investment over time. If you buy VIX futures with money you can’t afford to lose, then, you could be putting your portfolio in great danger indeed.
If you look at long term charts of the VIX, like the one of the VXX below, you will notice that it is typically trending lower with spikes when volatility picks. This is coincides with the overall market movements.
When the market spikes lower, you can expect the VIX to spike higher and then fade lower as market fear subsides.
Holding on to a long VIX position for multiple days can be dangerous. Traders usually use the VIX as a hedge against long market positions if they feel the market is over extended.
- Low liquidity
One other risk for traders is that liquidity on the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) can be anemic.
The stock market tends to be extremely volatile during periods of global economic uncertainty like in 2019 when extreme events happened around the world. Like the fierce U.S.-China trade war and the violent protests in Hong Kong and Europe.
Volatility negatively correlates to market returns which means that it rises when returns decrease and vice versa.
Therefore, investors ought to include assets such as VIX futures that are positively correlated with volatility in order to have a balanced portfolio.
VIX futures provide a great opportunity to protect portfolios from selloffs that result from market uncertainties and profit from implied volatility.
Above all else, having the VIX index on a streaming chart daily can help active traders gain valuable and useful information on the markets. However, it is important not to forget to pay attention to the risks involved with trading products tied to the index.