Volatility is a major factor in stocks and options investments. The Volatility Index (VIX) created by the Chicago Board Options Exchange (CBOE) has been a popular and closely watched indicator almost since its launch.Although VIX may or may not be a strict substitute for risk, investors and financial commentators still pay attention to this indicator to measure investors’ attitudes towards the market and possible short-term trading paths.
However, as an independent financial indicator, investors can also use VIX as a means to obtain profits or protect their investment portfolio.
- The CBOE Volatility Index (VIX) provides investors with an implied volatility index based on the S&P 500 option contracts listed in recent months.
- Sometimes, the VIX is called the “fear index” because rising volatility usually heralds downside risks.
- Since its launch, investors have been trading VIX value to speculate on investor sentiment or future volatility.
- The main way to trade on VIX is to use VIX derivatives or exchange-traded funds (ETF) and exchange-traded notes (ETN) related to VIX itself.
VIX-what is it (and not)
VIX is a weighted index that mixes several S&P 500 index options together. It is believed that the greater the premium of these options, the greater the uncertainty of the market direction. So in design, it is the square root of the 30-day cycle return, expressed in percentage points. Therefore, it should be a forward-looking representative of the short-term volatility expected by the market.
Although VIX is often used as a measure of investor fear (or complacency), it is not actually what it measures, because general optimism or pessimism will not cause VIX to be particularly high. Therefore, it may more be considered an “uncertainty index” (although it is fair to admit that there is a strong link between fear and uncertainty on Wall Street). Nevertheless, there is a negative correlation between the VIX and the S&P 500 index (meaning that they are moving in opposite directions).
It is also important to note that VIX is not technically a direct measure of risk. There is a lot of debate about what the real risk is, and some investors do use past or projected volatility as a proxy for risk. In other words, risk should be better viewed as the historical volatility of portfolio changes, rather than the expected ups and downs along the way.
How to trade VIX
Investors have multiple options to include VIX in their investment portfolio.
Exchange-traded note (ETN) is one of the most popular VIX trading methods. Similar to ETFs, ETNs allow investors to buy and sell instruments designed to replicate certain target indexes. As far as VIX is concerned, these ETNs hold a series of rolling VIX futures contracts.
ETN trading is relatively cheap, and any broker can handle the transaction. Investors must be aware that these are different from spot VIX. In addition, since volatility is a mean reversion phenomenon, VIX ETN may deviate from the spot VIX-during periods of low volatility (assuming volatility will increase) trading is higher than it should be, and during periods of high volatility it is lower At the level it should be.
Investors should also note that leveraged VIX ETN also has other shortcomings. Due to the repositioning that occurs in the portfolio, there is a phenomenon called “volatility lag” that can hurt performance. Although the leveraged volatility ETN is indeed closer to replicating the actual performance of the VIX, these tools are only really effective when held for a short period of time (because the volatility lag will erode returns over time).
VIX futures and options
More sophisticated investors can also choose to trade options and futures on the VIX index itself. Options and futures provide investors with greater leverage, so the potential for successful trading returns is greater. In other words, investors should keep some factors in mind. Options and futures usually charge higher commissions than stock trading, and futures traders need to maintain a minimum margin. Investors should also understand the different tax treatments for gains and losses, especially for futures contracts.Options and futures are also fixed-term investments, so investors must not only correctly grasp the direction of fluctuations, but also grasp the time frame.
VIX options are European options, which means they can only be exercised at expiration. More importantly, these options expire on Wednesday (unlike the more traditional Friday options expiration) and are settled in cash.Although the built-in leverage of options can generate magnified returns, investors should note that these options are indeed traded at the expected forward value and may deviate from the spot VIX.
In other words, due to European exercise and mean reversion of volatility, the trading price of VIX options is usually lower than during periods of high volatility (and vice versa during periods of low volatility), especially early in the option term
Like options, VIX futures are inherently leveraged and can replicate the trend of spot VIX better than ETN. However, investors should once again realize that the value of futures contracts is based on a forward-looking assessment of VIX. Depending on the outlook and the time remaining before settlement, the actual futures can be lower, higher or equal to the spot VIX.
In addition, there are allegations of VIX manipulation, and investors who have made major mistakes have been hit hard.
Alternative volatility strategy
There is no requirement that investors must use VIX and VIX-related tools to trade market volatility. In fact, in many cases, the VIX tool may not be an ideal hedging tool, whether because of cost, time frame, or the difference between the portfolio’s beta and the market. For investors who want other options, certain options strategies may be worth a look.
Stifling and straddling is a feasible way to trade the expected volatility of an index or a single security.
A long straddle strategy means buying call options and put options on the same security with the same strike price and expiry date. The biggest loss is the premium (plus commission) paid for the two options, and the potential gains are unlimited. Once the price is much higher (or lower) than the strike price to clear the premium and commission, the investor will make a profit.
In order to create a strangulation, investors purchase call and put options on the same underlying security with the same expiration date but different strike prices. The main advantage of using a choke is that it is cheaper to buy, but a choke also requires a greater price change to generate profits.
Simple put option
If investors just want to hedge market risks, then simple index put options may be the most effective option. Put options are applicable to almost all major stock indexes, and they are often quite liquid. Investors need to calculate their risk carefully and correctly (for example, buying S&P 500 put options to hedge a portfolio that is only loosely related to the S&P 500 index will not provide much protection), but puts are a very simple hedge The risk of short-term market corrections.
Although most investors want to stay away from volatility, others are willing to accept it and even try to profit from it. For those who wish to have a specific sense of recent market volatility, ETN may be a good choice, while options and futures provide traders with more benefits. However, given the shortcomings and costs of VIX-related investments, investors who wish to hedge their portfolios may only want to consider conventional put options as a cheaper option.