With volatility near multiyear lows, my email box has had more than the usual number of requests to discuss the pros and cons of trying to “play” volatility using one of the dozen or so volatility-based ETFs on the market.
On the one hand, I understand the appeal: If something seems artificially low, it’s logical to want to invest in it before it goes up. On the other hand, volatility exchange-traded products are some of the most complex ETPs trading.
The straw that broke the camel’s back was the recent spate of articles with headlines touting the enormous short position hedge funds have in volatility futures as some sort of evidence that volatility could somehow go even lower. I’ll come back to why that’s wooly thinking, but let’s start with what the heck an investment in a volatility ETF even is.
What Is The VIX?
At the root of most volatility ETFs is the CBOE Volatility Index (VIX). It’s often called the “fear index” and mislabeled “market volatility” on TV. What it actually is, however, is much more complex (and worth reading, if you’re a deep nerd).
The VIX is calculated using the implied volatility of a basket of options on the S&P 500—both those about to expire, and those expiring next month. The idea is to come up with a number that represents the level of volatility the options market is expecting in the S&P 500 over the next 30 days. It’s essentially reverse-engineering the math that options traders are using when they decide just how much to pay for a put or a call.
There are a few very important things to note here. The first is that there’s no direct mathematical relationship between the actual volatility of the S&P 500 and the VIX. The second is that it’s a forward-looking guess. The actual volatility of the market can be theoretically very low, while options traders are panicking about next month, sending VIX skyrocketing.
Similarly, the market could go bananas, and options traders could be sanguine about next month, and have VIX much less affected than you might expect.
VIX Rises When Markets Fall
In practice, what generally happens is that VIX rises substantially in response to downside surprises in the market. That’s why many investors have (for better or worse) seen an “investment” in VIX as a kind of hedge against market risk. It definitely has worked that way in short-term crises, like last August:
Practically speaking, you can’t just “buy” the VIX, unfortunately. Instead, the CBOE has futures contracts on the value of VIX that are widely traded. Like any futures contract, the VIX futures are simply a bet on where a particular number is going to land on a particular day in the future.
So while an oil future bought today might say, “I want the right to buy oil for $40 in a month,” and thus be worth $2 when oil is trading at $42 on settlement day, a VIX futures contract is pegged against a certain value for VIX.
To put it another way, a futures contract for a month out is betting on what options traders, a month from now, will be predicting the volatility of the S&P 500 will be for the 30 days after that. Not only are you not tracking actual market volatility, you’re buying a derivative (the futures contract) on a derivative (the implied volatility of the options).