How To Use Volatility ETFs

January 05, 2018

2017 will go down in stock market history for its volatility. Not because there was a lot of it―quite the opposite. The year featured one of the least-volatile stock markets in history, including a maximum drawdown of 2.8% (the smallest in history) and an average absolute daily price change of 0.3% (also the smallest in history).

The most famous gauge of U.S. stock market volatility, the Cboe Volatility Index—VIX for short—reflected the unusually tranquil backdrop of 2017. It fell to as little as 8.56, the lowest level ever for the gauge, which had broken below 9 only once before in its history.

The VIX doesn't measure actual, realized volatility. It measures what is known as implied volatility, which is calculated based on the price of near-term S&P 500 Index options. In other words, the VIX measures the market's best expectation of volatility over the next 30 days.

The VIX is low now, but it won't always be. The index has a tendency to revert to the mean. When the stock market sells off and expectations of volatility rise again―as they inevitably will―the VIX will spike. The long-term average for the gauge is 19.4, which, as of this writing, is double the current level of the index.

Given the high likelihood that the VIX will jump significantly from here at some point, you may be wondering whether there is some way to buy the index and profit from any potential upswing in it.

VIX Futures Explained

Unfortunately, the VIX itself―also known as spot VIX―is uninvestable: There's no way to buy or sell the popular gauge, because the underlying portfolio of options that the index measures is constantly changing. However, there are financial products closely tied to movements in the index.

VIX futures contracts allow traders to bet on what value the index will be at some date in the future. Cboe lists a number of weekly and monthly VIX futures contracts whose values fluctuate based on where traders believe the level of the VIX will be at the contract's expiration date.

The value of VIX futures tends to converge with spot VIX as a contract's expiration nears, but can deviate significantly from spot for contracts where expiration is far in the future.

For example, as of this writing on Jan. 3, VIX futures that expire on Jan. 10 were trading at 10, modestly above the spot level of 9.15. However, VIX futures that expire on Sept. 19, 2018 were trading around 16, significantly above current spot levels.

 

Source: Bloomberg

 

When the spot VIX is low, VIX futures typically trade at a premium (also known as contango). When spot VIX is high, the futures tend to trade at a discount (also known as backwardation) as traders anticipate an eventual reversion to the mean.

VIX ETFs

VIX futures aren't the only way to get exposure to the volatility index. Like many financial assets, VIX futures have been packaged into ETF wrappers in various ways, making it easier for investors and speculators to bet on volatility.

The $875 million iPath S&P 500 VIX Short-Term Futures ETN (VXX), launched in 2009, was the first product to offer exposure to VIX futures. It holds futures contracts with an average maturity of one month.

 

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