What Are 4 Ways To Trade The VIX?

The one constant on the stock markets is change. Said differently, volatility is a constant companion to investors. Ever since the VIX Index was introduced, with futures and options following later, investors have had the option to trade this measurement of investor sentiment regarding future volatility.

At the same time, realizing the generally negative correlation between volatility and stock market performance, many investors have looked to use volatility instruments to hedge their portfolios.

Understanding 4 Ways To Trade The VIX

Starting Points

One significant factor in assessing exchange-traded funds (ETFs) and exchange-traded notes (ETNs) tied to the VIX itself. VIX is the ticker symbol that refers to the Chicago Board Options Exchange Market Volatility Index. While often presented as an indicator of stock market volatility (and sometimes called the "Fear Index") that is not entirely accurate.

Key Takeaways

  • Since the Chicago Board Options Exchange Market Volatility Index (VIX) was introduced, investors have traded this measure of investor sentiment about future volatility.
  • The primary way to trade the VIX is to buy exchange-traded funds (ETFs) and exchange-traded notes (ETNs) tied to the VIX itself.
  • There are many popular ETFs and ETNs that relate to the VIX, including the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the VelocityShares Daily Two-Times VIX Short-Term ETN (TVIX).

VIX is a weighted mix of the prices for a blend of S&P 500 index options, from which implied volatility is derived. In plain English, VIX really measures how much people are willing to pay to buy or sell the S&P 500, with the more they are willing to pay suggesting more uncertainty.

This is not the Black Scholes model—the VIX is all about "implied" volatility. What's more, while VIX is most often talked about on a spot basis, none of the ETFs or ETNs out there represent spot VIX volatility. Instead, they are collections of futures on the VIX that only roughly approximate the performance of VIX.

A Host of Choices

The largest and most successful VIX product is the iPath S&P 500 VIX Short-Term Futures ETN (ARCA:VXX). This ETN holds a long position in first- and second-month VIX futures contracts that roll daily. Because there is an insurance premium in longer-dated contracts, the VXX experiences a negative roll yield (basically, that means long-term holders will see a penalty to returns).

Because volatility is a mean-reverting phenomenon, VXX often trades higher than it otherwise should during periods of low present volatility (pricing in an expectation of increased volatility) and lower during periods of high present volatility (pricing a return to lower volatility).

The iPath S&P 500 VIX Mid-Term Futures ETN (ARCA:VXZ) is structurally similar to the VXX, but it holds positions in fourth-, fifth-, sixth-, and seventh-month VIX futures.

Accordingly, this is much more a measure of future volatility and it tends to be a much less volatile play on volatility. This ETN typically has an average duration of around five months and that same negative roll yield applies—if the market is stable and volatility is low, the futures index will lose money.

For investors looking for more risk, there are more highly leveraged alternatives. The VelocityShares Daily two-times VIX Short-Term ETN (ARCA:TVIX) does offer more leverage than the VXX, and that means higher returns when VIX moves up.

On the other hand, this ETN has the same negative roll yield problem plus a volatility lag issue—so this is an expensive position to buy-and-hold and even Credit Suisse's (NYSE:CS) own product sheet on TVIX states "if you hold your ETN as a long-term investment, it is likely that you will lose all or a substantial portion of your investment."

Nevertheless, there are also ETFs and ETNs for investors looking to play the other side of the volatility coin. The iPath Inverse S&P 500 VIX Short-Term ETN (ARCA:XXV) basically looks to replicate the performance of shorting the VXX, while the VelocityShares Daily Inverse VIX Short-Term ETN (ARCA:XIV) likewise seeks to deliver the performance of going short a weighted average maturity of one-month VIX futures.

Beware the Lag

Investors considering these ETFs and ETNs should realize that they are not great proxies for the performance of the spot VIX. In fact, studying recent periods of volatility in the S&P 500 SPDR (ARCA:SPY) and the changes in the spot VIX, the one-month ETN proxies captured about one-quarter to one-half of the daily VIX moves, while the mid-term products did even worse.

The TVIX, with its two-times leverage, did better (matching about half to three-quarters of the performance), but consistently provided less than fully two-times the performance of the regular one-month instrument. Moreover, because of the negative roll and volatility lag in that ETN, holding on too long after the periods of volatility started to significantly erode returns.

If investors really want to place bets on equity market volatility or use them as hedges, the VIX-related ETF and ETN products are acceptable but highly-flawed instruments. They certainly have a strong convenience aspect to them, as they trade like any other stock.