The VIX, often called the “fear index,” is a real-time market index representing the market’s expectations for volatility over the coming 30 days. It is calculated and published by the Chicago Board Options Exchange (CBOE) and primarily measures the market’s expectation of future volatility derived from the prices of S&P 500 index options.
High VIX values indicate increased market volatility expectations, often correlating with market uncertainty or fear, while low VIX values suggest stability or complacency among investors. As such, traders and investors closely watch the VIX to gauge market sentiment, manage portfolios, and hedge against market downturns.
How to Buy VIX?
Traders can not buy the VIX index directly or a basket of underlying components to mimic the VIX. However, traders and investors can hold VIX ETFs to track market volatility via holdings of VIX futures contracts.
Investors cannot directly trade the VIX index, which measures the stock market’s volatility expectations; instead, they access its movements through VIX Exchange-Traded Funds (ETFs) that typically track VIX futures indexes. These VIX ETFs, often structured as Exchange-Traded Notes (ETNs), carry inherent risks, including the risk associated with the futures market and the counterparty risk linked to the creditworthiness of the issuing bank.
Here’s a brief overview of the VIX ETFs with the best one-year trailing total returns:
- VXZ (iPath Series B S&P 500 VIX Mid-Term Futures ETN): This Exchange-Traded Note (ETN) aims to provide exposure to the S&P 500 VIX Mid-Term Futures Index, which reflects the implied volatility of the S&P 500 Index at various points along the volatility futures curve. VXZ focuses on mid-term futures, which can be less sensitive to daily market movements compared to short-term volatility futures, potentially offering a smoother performance over periods of market turbulence.
- VIXM (ProShares VIX Mid-Term Futures ETF): Similar to VXZ, VIXM targets mid-term S&P 500 VIX futures. It is structured as an ETF, meaning it holds the actual futures contracts. This focus on mid-term futures allows VIXM to capture aspects of market volatility with potentially less roll cost than short-term VIX futures ETFs, making it an option for investors looking to hedge longer-term volatility or speculate on future market movements.
- SVOL (Simplify Volatility Premium ETF): Unlike VXZ and VIXM, which are directly tied to VIX futures, SVOL takes a different approach to capturing volatility. It seeks to provide investors with exposure to volatility through a variety of strategies, including options and futures, aiming to capitalize on the volatility premium—the difference between implied volatility and realized volatility. SVOL’s strategy may involve more sophisticated risk management techniques, targeting investors seeking to benefit from volatility as an asset class.
These ETFs/ETNs provide different ways for investors to engage with market volatility. VXZ and VIXM offer more direct exposure to mid-term VIX futures, potentially suitable for those looking to hedge against or speculate on future volatility over a longer horizon. In contrast, SVOL presents a strategy that aims to exploit the volatility premium, potentially appealing to those looking for an alternative approach to volatility trading. As with any investment, it’s important to consider the inherent risks and conduct thorough research or consult with a financial advisor to ensure alignment with one’s investment goals and risk tolerance.
Despite these risks, the structure of VIX ETFs allows for the creation of diverse products, including those that provide direct exposure to volatility and inverse ETFs that profit from declining volatility. One notable product, the iPath S&P 500 VIX Short-Term Futures ETN (VXX), strategically holds positions in the first and second-month VIX futures contracts, aiming to capitalize on the market’s volatility trends. Conversely, inverse VIX ETFs like the ProShares Short VIX Short-Term Futures ETF (SVXY) offer investors a way to hedge against or benefit from decreases in market volatility, although these products can experience significant fluctuations in value.
The volatility of these ETFs was highlighted during the 2018 market turmoil when inverse VIX products faced massive losses, leading to the closure of several such funds. This dynamic underscores the high-risk, high-reward nature of VIX ETFs and ETNs, demonstrating the importance of understanding their complexities before investing.
Here is why you should avoid trading VIX:
- Implied Volatility vs. Direct Volatility: The VIX measures “implied” volatility based on S&P 500 index options prices, reflecting how much investors are willing to pay for market protection, not direct market volatility. This distinction makes VIX ETFs an indirect measure with inherent limitations.
- Inaccuracy in Mirroring the VIX: VIX ETFs, especially one-month ETN proxies, capture only a fraction (about 25% to 50%) of daily VIX movements, with mid-term products performing even less effectively. This discrepancy is due to the challenge VIX futures indexes face in accurately emulating the actual VIX index.
- Decay Over Time: VIX ETF positions often suffer from decay over time because of the structure of the VIX futures curve. This decay reduces the funds available for rolling into future contracts, leading to a gradual loss of value in these ETFs.
- Long-term Value Erosion: The repeated process of decay and rolling of contracts in VIX ETFs typically results in long-term financial loss, undermining their viability as a long-term investment.
- Extreme Volatility of Inverse ETFs: Inverse volatility ETFs are prone to significant losses during market volatility spikes, to the extent that they can be virtually wiped out by a brief period of heightened volatility. This extreme sensitivity makes them highly risky.
- Not for the Faint-Hearted: The dramatic potential losses associated with inverse volatility ETFs mean they are unsuitable for investors without a deep understanding of volatility mechanics or those averse to high risk.
- Short-term vs. Long-term Investment: Given their volatility, inverse VIX ETFs may be considered more for short-term speculative opportunities rather than as stable, long-term investment assets, highlighting the importance of understanding the product and market dynamics before investing.
The VIX, commonly referred to as the “fear index,” is calculated using the premium prices of near-the-money S&P 500 index option calls and puts for the nearest and subsequent month, providing a weighted average of implied volatility. This method, standardized post-2003, evolved from an older approach that utilized 8 series of at-the-money calls and puts from the S&P 100 index to gauge implied volatility.
Implied volatility, at its core, mirrors market investors’ consensus expectations about the S&P 500 index’s volatility over the upcoming 30 days. Essentially, the VIX quantifies the premium investors are willing to pay as a hedge against their investment risk, with the index’s magnitude indicating the level of market volatility anticipated by investors. A higher VIX value signals increased investor concern about future market volatility, suggesting a lack of confidence in market conditions. Conversely, a lower VIX indicates a forecast for less drastic changes in the stock market, implying a more stable or bullish outlook among investors.
The VIX thus serves as a barometer for investor sentiment, rising during times of market distress or uncertainty and decreasing when confidence returns. When the VIX reaches unusually high or low levels, it reflects extreme investor reactions, whether driven by panic or excessive optimism, affecting the cost considerations of protective options.
VIX and ETF correlation
The latest scientific research on the correlation between the VIX (Volatility Index) and ETF (Exchange-Traded Fund) returns has yielded several key insights into how market volatility influences ETF performance across different markets. Here’s a summary of the findings:
- Stronger Impact on Single Market ETFs: The VIX has a more pronounced effect on ETFs that are focused on a single market compared to those that track European markets. This indicates that the VIX, which is based on S&P 500 index options, is more closely aligned with the volatility and performance expectations of ETFs tied to the U.S. market.
- Short-term Influence on European Market ETFs: While the overall impact of the VIX on European market ETFs is less significant, it has been found that the VIX’s daily returns exert a stronger short-term effect on these ETFs. This suggests that, in the short run, European market ETFs are more sensitive to the immediate fluctuations in market volatility as indicated by the VIX.
- Lower Impact Compared to S&P 500 Returns: The study also highlights that the VIX has a lesser impact on ETF returns when compared to the direct influence of S&P 500 returns. This underscores the idea that while the VIX is a valuable indicator of market sentiment and volatility, the actual market performance (as represented by the S&P 500 returns) has a more direct and stronger effect on ETF performance.
- High Correlation in the US Market: In the U.S. market, there is a significant correlation between the VIX and lagged market index ETFs, which is attributed to overlapping information sets. This means that the information that influences the VIX and the information that affects U.S. market ETFs tend to overlap significantly, leading to a higher correlation between the two. This correlation suggests that changes in market volatility, as measured by the VIX, are closely linked to subsequent changes in U.S. market index ETFs.
These findings contribute to a deeper understanding of the dynamics between market volatility and ETF performance, particularly highlighting the variable impact of the VIX across different markets and time frames. Investors and financial professionals can use these insights to better navigate investment decisions in volatile markets, taking into account the nuanced relationship between the VIX and ETF returns.
He is an expert in financial niche, long-term trading, and weekly technical levels.
The primary field of Igor's research is the application of machine learning in algorithmic trading.
Education: Computer Engineering and Ph.D. in machine learning.
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