Trading the VIX
VIX is the name and ticker symbol for the CBOE Volatility Index, which measures implied volatility of S&P 500 index options. As markets become indecisive it could be profitable to look at volatility indices. They are great trading tools in a down-turning market although do carry risks all investors should be aware of when trading the VIX.
The VIX is calculated by the Chicago Board Options Exchange (CBOE). The VIX measures the market’s expectations for volatility over the next 30 days. The index tracks put and call options of the S&P 500. Currently, the VIX is the most widely used method of measuring expected volatility.
Usually, a VIX value below 20 suggests low volatility and means prices are not changing in a dramatic fashion. On the contrary, a VIX reading above 30 suggests high volatility. This means uncertainty is high and fear has increased in the market. This is why the VIX is sometimes called the “fear index.”
Trading the VIX, VIX-Linked Products allow investors and traders to gain exposure directly to movements in the VIX.
There are many options to trade the VIX. The simplest is to buy Exchange Traded Notes (ETN) or Exchange Traded Funds (ETF) which are linked to elements of the index. The clear majority of money invested in volatility related ETN’s are bets that volatility will increase. Most of these bets are speculative although the VIX can be also used towards portfolio insurance. However, holding longer term bets on the VIX have proven to be expensive as the holding costs are high.
VIX Related Products
The largest vehicle is the iPath S&P 500 VIX Short-Term Futures ETN (VXX) . This ETN invests in long positions in the first and second month VIX futures contracts. So, if markets become insecure and volatility increases, the product gains in value. It is advisable to understand that these products are subject to a market mechanism called contango and should generally not be held for long periods of time. Also, worthy of notation is that you cannot gain exposure directly to the VIX. As a result short term ETN’s such as VXX are usually linked to a short term index comprising of VIX futures, for example SPVXSP. Therefore the source of most people’s frustrations with trading VIX ETN’s is expecting them to track the widely-published CBOE VIX Index. They generally do NOT track the VIX directly.
Investors should understand that VIX-related products are designed for knowledgeable traders. Traders who can assess the risks and better understand market movements. Traders who understand the concept of volatility, how is it calculated and are familiar with the basic structure of the VIX, will find this a great tool to trade.
In addition to the above, when the VIX is high, it can be profitable to buy ETFs tracking the S&P 500. Once the VIX is above 30, traders become rattled and are selling their stocks based more on emotions. This tends to lead to more rapidly falling stock prices which may become oversold. When the VIX begins to decline, it can be a good time for investors to begin stock picking and buy.