Portfolio Applications For VIX-Based Instruments

October 26, 2011

Unfortunately, it is not possible to own the VIX. Investors can gain exposure to equity volatility by investing in futures and options on the VIX as well as ETPs linked to VIX futures indexes, but each of these has specific performance characteristics that should be well understood before investing.

Investable Instruments
In 2004, CBOE introduced futures on the VIX. This gave market participants the ability to gain exposure to equity volatility in exchange-traded markets. One of the challenges with trading VIX futures is that they cannot be arbitraged. It is not possible to own spot VIX, and therefore if a trader believes the futures are mispriced relative to the spot price, it is not possible to buy spot and sell futures (or vice versa) to exploit mispricings. Unlike most futures markets, there is no direct linkage between the VIX and a given futures contract. So while the level of the futures contracts is theoretically an indicator of market expectations about future VIX levels, it is in fact dictated solely by supply and demand; there is no market mechanism to connect the futures and spot price. This means that there is the potential that the level of the futures does not accurately represent the market’s expectation for future volatility.

This pricing dynamic leads directly to the single largest concern for investors looking to hedge their exposure to the equity market with VIX futures: the cost of implementing the hedge. The severe contango, or upward-sloping term structure, that generally exists in the VIX futures market makes the cost of buying and holding long positions in VIX futures prohibitively expensive. Since the inception date of VIX futures indexes in 2005, the average contango from the first to second nearby contracts has been 3.8 percent per month. This means that on average, VIX would have to rise by that amount per month for the holder of the contract to break even. VIX futures can be an effective hedge for short holding periods, but the cost of hedging with VIX futures can be very high.

SPX/VIX Excess Return Vs. Volatility

S&P 500 VIX Futures Indexes
While the CBOE has been publishing the VIX since 1993, it wasn’t until 2009 that an investable index emerged. Standard & Poor’s launched a pair of VIX futures indexes: the S&P 500 VIX Short-Term Futures Index (SPVXSP) and the S&P 500 VIX Mid-Term Futures Index (SPVXMP). The short-term index measures the return from daily rolling weighted long positions in the first- and second-month VIX futures contracts. The midterm index measures the return from daily rolling weighted long positions in the fourth- through seventh-month VIX futures contracts. To maintain a constant average maturity, the weighting of the positions in the futures contracts rolls on each trading day. The specifics of the indexes are presented in Figure 5.

VIX Index And VIX Futures Indexes

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