Volatility is something that all investors need to understand and monitor. But can it also be used as a tool for protecting yourself in the market? Used as an index, VIX can help keep an eye on the ways in which the market is trending. Eventually it morphed into a way to potentially hedge against risk when the market trends downward. Wondering how to buy VIX? Wondering what VIX really is? Want to know about the alternatives? We’ll get into all of this and more!
Let’s take a closer look at what VIX is, whether it’s risky, and what the best ways are to invest in this index.
What is VIX?
Alright, so for starters…What is VIX?
You may have heard it referred to as VIX, The VIX, or the fear gauge, but VIX is simply the ticker symbol referring to the Chicago Board Options Exchange Volatility Index.
It started out as an index of volatility with the options, but has turned into a trading instrument. But what is this VIX fund actually telling us?
Put simply, it’s a measure of how people feel the market is doing, of how much volatility investors expect to see over the next 30 days.
If you believed the market was going down, you would want to know if there’s anything you can do to hedge your risk, or keep your risk under control. Essentially, what can you do to protect yourself against a market downturn. You could step into the world of options.
What Does It Mean When The VIX Goes Up?
What the VIX tells us is that if enough people are thinking the same way you are, that the market is going down, the more people will start to use those options. The option prices expand, which means people are paying more to protect themselves.
When a lot of people are nervous, more people are buying options, and the VIX goes higher. The more people that are buying something, the higher the prices are going up. VIX goes up when people are nervous about the market, and down when people are comfortable with how things are going.
The VIX is calculated based on the prices of the S&P 500 stock options. (Stock options give you the right but not the obligation to purchase an asset at a specific time and price.)
Why Does the VIX Spike? …And When Does The VIX Spike?
During periods when the market is more volatile, the pricing of the stock options is higher. This is because when something is more volatile it’s more likely to hit the strike price, the price that you can buy the option at.
During a market selloff, the implied volatility as measured by VIX tends to spike, and so investors like to invest in VIX as a way to hedge their portfolio, because their VIX exposure is going up in value at the same time the stock market is going down. (Theoretically, of course.)
This type of investment is full of risk, and we’ll discuss that more below.
Why do we track how people are feeling about the market? Because investors always want to know what the expected returns are.
The VIX gives us more information about how people feel about the way the market is performing, and thus, where, if, and when they’ll be investing their money.
It can also give us a sense of the way people react to external stimuli as it relates to investing.
VIX and VVIX
Now we’re going to get a little bit inception-y here, but there’s not just the VIX. There is also the VVIX, or the CBOE VIX Volatility Index. This measures the volatility of the volatility index. Just like the VIX uses options to measure expected volatility in equities, the VVIX measures VIX options to measure expected volatility in…volatility. (Is your mind blown yet?? Lol!)
How the VVIX Works
Here’s how it works: if VVIX is low, then expectations are for volatility, or fear, to also be low. Sometimes the VIX and VVIX line up and track together, and sometimes they don’t at all.
VIX and VVIX Divergence
One possible interpretation for why the VIX would be low and the VVIX would be on an uptrend, for example, is that it’s telling us that while underlying volatility is low (VIX), it may not be for long (VVIX). In this way, the VVIX is sometimes thought of as a trending tool for volatility.
Is there a risk with investing in VIX?
The short answer is: yes.
Examples of Why Investing in VIX is Risky
The VIX is often in contango, which happens when the futures price is higher than the current price.
If you bought VIX today and the spot price was 11, but you look at the one-month futures contract and it’s at 14, you would need to somehow know that 30 days from now the spot price would be trading higher than 14 in order to make money on your investment.
This means that if it falls short of that, you’re losing money.
Another example, VIX ETFs can spike 60% in one month because the VIX jumps, but the year-to-date could still be at -5%, because the rest of the year it was losing money.
This makes it a short-term investment to potentially protect yourself from risk that you need to monitor daily.
VIX investments are not buy-and-hold investments. They are for short-term, and for people who can watch it and get out quickly if the market turns. The bet you’re making when you invest in VIX is “do I think volatility will spike in the next 30 days”. And you just have no way to get solid informational insight into whether or not it will go up, it’s an educated guess.
Another aspect that makes it risky is knowing that just because an investment follows the VIX, it doesn’t mean it grows or falls in line with the actual index.
Yet Another Risk of VIX
The timing can be so tight that there’s a lag between a good time to get in and get out, and a bad time. Even long-time professionals have a hard time with this type of investment vehicle.
There are also times when the VIX goes up, but the ETFs that track them go down.
Because there’s no real knowledge about performance, it makes VIX a risky investment.
Ok, so you’ve considered the risk, and you understand what you’re investing in.
How do you buy VIX?
Or put another way, how do you trade VIX?
Can You Buy VIX Directly?
Long story short, VIX is an index, so you can’t buy it directly.
Okay, next question…
If you can’t buy VIX directly, is there an ETF that tracks the VIX?
What is the best way to buy VIX?
The best way to buy VIX is through Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs) that are connected to VIX.
These work by buying futures contracts, and the ETFs themselves are investing in the shortest or closest contracts. The ETNs are issued as senior debt notes by a financial institution, and don’t own a stake in the underlying company like ETFs do.
What Are The Best VIX ETFs?
Do you understand all the risks and warnings mentioned above? Are you still wanting to learn how to trade VIX?
If you think you’re ready to invest in this type of fund, you’re probably wondering, “What is the best VIX ETFs?” Or, if there is more than one option, “What are the best VIX ETFs?”
There are a few ETFs out there relating to VIX, but we’ll focus on the best four VIX funds (in our opinion) here:
So…this fund is called the VXX. What really is the VXX vs VIX?
Long story short, they’re not really versus one another. The VXX is a fund that tracks the VIX.
What is VXX?
VXX is one of the biggest and best performing VIX ETNs.
It’s a 30-year ETN that holds first and second month futures, with a maturity date of January 23, 2048.
Long-term holders of this ETN will see a penalty to returns because it experiences a negative roll yield.
It typically trades higher than it should during low volatility, the pricing reflecting an expectation that volatility is coming.
During periods of high volatility it trades lower, trying to price a return that will lower the volatility.
2) iPath S&P 500 Dynamic VIX ETN (VXZ)
This ETN is set up the same way as VXX, but it holds futures from months four through seven.
It functions in the same way with a negative roll yield, and has the same maturation date.
It’s slightly less volatile because it’s a measure of future volatility, rather than the next month or two.
3) ProShares Short VIX Short-Term Futures ETF (SVXY)
This is an inverse ETF that aims for daily investment results that are equal to one-half the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index.
This means it must be monitored daily, as it bases its return on a single day benchmark.
Monitor this investment daily! Inverse ETFs that are held for more than a day can lead to big losses.
4) ProShares Ultra VIX Short-Term Futures ETF (UVXY)
This fund seeks to track 1.5 times the daily performance of the S&P 500 VIX Short-Term Futures Index. These are one-to-two month futures.
This also needs to be closely monitored as it bases its return on a single day benchmark as well.
If you’re still wondering about the best way to buy VIX funds, we just covered it. (Sorry to be so blunt! :)) The four funds above are some of the best VIX funds out there. You want to invest in VIX? Then start with those.
How to Buy VIX – In Summary
VIX is a measure of how people feel about the state of the market.
It’s used as an investment index for short-term investment only, tracking the volatility of the stock options on the S&P 500.
The best way to invest in VIX is to buy an ETF that is closely tied to VIX.
Many of these funds need to be monitored daily, and are best for experienced investors familiar with the risk of trading them.
What do you think? Will you start trading VIX funds? Or are they too risky for your investment style?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.