Investors would do well to heed the words of Lao-Tzu, legendary Chinese philosopher: "Seek not happiness too greedily, and be not fearful of unhappiness". Unfortunately, greed and fear still drive human behavior 26 centuries later. The new VIX index (symbol VIX), based on the short-term volatility of options available on the S&P 500 index, allows the savvy investor to capitalize on this irrational behavior. Here we'll explain the evolution of this popular volatility index, why there were changes to the index and why you should consider volatility as a separate asset class.

See: Volatility's Impact On Market Returns

With the introduction of the new VIX index in 2003, volatility has now become an asset class, tradable through the use of futures. (There are plans to introduce VIX options in the near future.) VIX futures and options are both negatively correlated with equities market performance.

The development of this new asset class is one of the more important developments in the options market since the introduction of the Black-Scholes pricing model in 1973. Given recent developments in calculation and derivative products, new opportunities are now available in portfolio construction and trading. (To learn more, see Volatility Index Uncovers Market Bottoms.)

Figure 1 - This graph shows the historical trends and correlation between the VIX and S&P 500.

Reasons for the Change
The old measure of VIX (symbol VXO), developed in 1993, was based on the S&P 100 and was neither precise nor robust enough to be used in the creation of derivatives (remember that for an asset class to be of use, it must be tradable).

Figure 2 - This graph shows a minimal tracking difference between the new and old VIX.

VIX addressed a number of problems that existed with the VXO. One, the index needed to be based on a more liquid index like the S&P 500. The S&P 500 has many more derivatives and swaps based off of it - liquidity feeds liquidity. Two, VXO used the Black-Scholes option-pricing model - a complex and unpopular model for valuing volatility - with only eight at-the-money options rather than the wide range of options based on the liquid S&P 500 index.

VIX, on the other hand, uses a weighted-average price of all outstanding options used in calculating VIX (see the Chicago Board Options Exchange (CBOE) website for more info). This is more in line with the way the investment community values volatility. Therefore, this new methodology offers traders a volatility index that is more representative of the entire market. With this new pricing method, historical pricing of the VIX is easy to calculate (CBOE supplies this data going back to 1986). The availability of this kind of historical data leads to some exciting backtesting possibilities.

Birth of a New Asset Class
With the new VIX, derivatives can now be created for this asset class. Futures were the first, and options are in the works. VIX futures started trading in May 2004. While trading futures would not be classified as a retail product, exchange-traded funds (ETF) based on futures would change that. (For more on ETFs, see Introduction To Exchange-Traded Funds.)An ETF based on VIX would just roll futures contracts as they became due.

The negative correlation between VIX and the equity market is well documented.

Figures 3 and 4 - These two graphs clearly show the negative correlation between the S&P 500 and the VIX index with large movements in the S&P 500.

"Loss aversion" (being more averse to losses than gains), as it is known in the world of behavioral finance, is validated within the VIX world. The risk/return trade-off with VIX tends to be asymmetrical, meaning decreases in the S&P 500 will have larger effects on volatility than increases.

Option volatility also exists outside of the equity markets. Such securities as convertible bonds and mortgage-backed securities have embedded call options in them. Given the high correlation between credit spreads and volatility as noted in Kopin Tan's article "The ABCs of VIX" (Barron's, Mar 2004), VIX derivatives could also be used as a hedging vehicle within fixed income.

A case has even been made for the inclusion of VIX in a balanced portfolio. In his article "Taking a Ride on the Volatile Side" (Journal of Indexes, Fourth Quarter 2004), Matthew Moran notes that a portfolio based on 10% VIX and 90% S&P 500 rebalanced weekly would have outperformed the S&P 500 by 5% while reducing risk by 25% (based on data from 1986 to 2003).

Finally, it should be remembered that changes in volatility will have less of an effect on long-term options than short-term options - things are more certain in the long-term.

The Bottom Line
In a low interest rate environment, the need to add portfolio value is intensified for the average investor. The introduction of a volatility asset class that is negatively correlated with equities makes this job a bit easier. For over a decade, investors were intrigued by the VXO, which became know in the press as the "fear gauge," for its ability to measure the amount of anxiety in the equity market, but now there is an opportunity to trade volatility with VIX futures. Volatility-based options and ETFs cannot be far away for the retail investor. Keep your eye on further developments, because one day you might be able to trade S&P 500 volatility as easily as you can trade the S&P 500 index today.

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