VIX Index Strategies

The VIX Index, often referred to as the “fear gauge” of the financial markets, measures the market’s expectation of volatility over the next 30 days.

Originating from the Chicago Board Options Exchange (CBOE) on the first market day of 1990, it reflects sentiment and anticipated fluctuations in the S&P 500 Index options.

When the VIX is high, it indicates that traders/investors expect significant changes in the stock market.

A low VIX suggests a calmer, more stable environment.

It serves not only as a barometer of market anxiety but also something that can be traded directly.

Key Takeaways – VIX Index Strategies

• Trading VIX futures is common for hedging and speculation.
• Buying VIX call options for protection or volatility spikes.
• Writing (selling) VIX call options to collect premiums.
• Using spreads like bull call spreads in VIX options to capture a more limited up-move in implied volatility.
• Trading VIX ETFs and ETNs for volatility exposure or hedging.
• Hedging portfolios with VIX instruments.
• Exploiting the volatility risk premium by selling volatility.

Trading VIX Futures

Basics of VIX Futures

VIX futures are derivative contracts that allow traders to speculate on the future value of the VIX Index.

Introduced in 2004, these futures provide a direct way to gain exposure to volatility without trading options.

They are standardized contracts traded on the CBOE Futures Exchange, with expiration dates extending out for several months (generally close to a year).

It can be represented via a futures curve, where each point represents one month.

There can be kinks in the curve because of certain anticipated events or due to differences in activity/liquidity.

Per the diagram, VIX futures prices can differ from the current VIX Index (i.e., spot price) due to expectations of future volatility.

This difference arises because futures prices incorporate market forecasts about where volatility is headed.

Traders need to understand the term structure of VIX futures, which can be in contango or backwardation, as this affects the pricing and potential returns of their strategies.

There’s also a “mini VIX” product available if standard VIX comes in too large of an increment.

This mini product is under the symbol VXM. Naturally, it’s less liquid, as most “mini” futures products tend to be as they’re more geared toward smaller traders.

Typical VIX Values

VIX spends most of the time between 10 and 30 with intermittent spikes above that range.

(Source: Chicago Board Options Exchange)

Here’s a breakdown of what different VIX levels generally signify:

• VIX below 10
  • Indicates low expected volatility and a calm market environment.
  • Traders are generally complacent, expecting stable market conditions.
  • Sub-10 levels are generally rare. We saw this in 2017 but it generally doesn’t last long and can create the buildup of short vol exposures that aren’t sustainable long-term.
• VIX between 10 and 20
  • Represents a normal or average level of expected volatility.
  • Reflects a healthy market with some fluctuations but no major concerns.
• VIX above 20
  • Suggests heightened expected volatility and increased market unknowns.
  • Traders are generally more fearful or anxious, anticipating larger price swings – and on not, less inclined to own equities (i.e., demand higher risk premiums).
• VIX above 30
  • Signals significant expected volatility and a high degree of market fear.
  • Often associated with market corrections or crises.

Some other points to consider:

• VIX is a forward-looking indicator – It reflects market expectations, not guaranteed future volatility.
• VIX levels are relative – What’s considered “high” or “low” can change over time depending on the market environment.
• VIX can be a contrarian indicator – Extremely high levels can sometimes signal a market bottom, as fear reaches a peak.

Strategies Using VIX Futures

One common strategy is using VIX futures for hedging purposes.

Traders/investors holding a portfolio of equities might buy VIX futures to protect against sudden market downturns.

Since the VIX often moves inversely to the S&P 500, gains in VIX futures can offset losses in the equity portfolio during periods of high volatility.

Speculators might also trade VIX futures to profit from expected changes in market volatility.

For instance, if a trader anticipates an increase in volatility due to upcoming economic events, they might purchase VIX futures in hopes of selling them at a higher price later.

Conversely, selling VIX futures could be profitable if a decrease in volatility is expected.

VIX Options Strategies

Understanding VIX Options

VIX options are another instrument that allows traders to speculate on future volatility.

Unlike standard equity options, VIX options are European-style and settle in cash based on the VRO settlement value* of the VIX futures.

They provide a way to leverage positions on volatility with defined risk.

The pricing of VIX options is influenced by factors such as time to expiration, implied volatility, and the underlying VIX futures price.

Traders must grasp these nuances to effectively implement options strategies.

Since VIX options can behave differently from equity options, specialized knowledge is essential.

*VRO is a special calculation used to determine the final settlement value of VIX futures and VIX options contracts.

It’s calculated using the opening prices of a specific set of S&P 500 index options on the expiration date.

Popular VIX Options Strategies

One popular strategy is the VIX call option purchase.

Traders hedging their equity/risk asset portfolio might buy VIX calls.

Or those expecting a spike in volatility might buy call options on the VIX, which can yield significant returns if the VIX rises sharply.

This strategy involves limited risk – the premium paid for the option – with potentially substantial rewards.

Another strategy is selling VIX call options, known as writing calls.

Traders who believe that volatility will remain low might sell VIX call options to collect the premium.

This strategy nonetheless carries unlimited risk if the VIX surges unexpectedly, so it’s typically used by more experienced traders.

Spreads are also common in VIX options trading.

For example, a trader might use a bull call spread by buying a VIX call option at a lower strike price and selling another at a higher strike price.

This approach limits both potential profits and losses, providing a balanced risk-reward profile.

It can be useful for those who want a hedge on their risk asset portfolio but want to defray the cost of protection (i.e., provided by the put option).

Using VIX ETFs and ETNs

Overview of VIX ETFs and ETNs

ETFs and ETNs linked to the VIX provide accessible ways for traders to gain exposure to volatility.

Products like the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the ProShares VIX Short-Term Futures ETF (VIXY) track VIX futures indices, offering liquidity and ease of trading.

These instruments bundle VIX futures into a single product, which allows traders to buy and sell shares on the stock exchange.

They’re subject to the dynamics of VIX futures, including roll costs and the effects of contango and backwardation.

Understanding these factors is important for effective use of VIX ETFs and ETNs.

Strategies Involving VIX ETFs and ETNs

Traders might use VIX ETFs and ETNs for hedging purposes.

By adding these instruments to their portfolios, they can potentially help offset losses during market downturns.

For example, during periods of market stress, VIX-linked ETFs often increase in value, providing a counterbalance to declining equity positions.

Speculative strategies also involve trading VIX ETFs and ETNs based on expected changes in volatility.

Short-term traders might capitalize on anticipated volatility spikes by purchasing shares of VIX ETFs.

Conversely, if they expect volatility to decrease, they might short these ETFs, although this involves a lot risk when losses have unlimited upside and require margin accounts.

Hedging with VIX

Portfolio Hedging Using VIX

Hedging with the VIX involves taking positions that will appreciate when market volatility increases, thus offsetting losses in other parts of the portfolio.

Since the VIX typically moves inversely to the stock market, incorporating VIX-related instruments can provide a form of insurance against market downturns.

For instance, a trader might allocate a small percentage of their portfolio to VIX call options or VIX ETFs.

During a market decline accompanied by rising volatility, these positions could gain value, reducing overall portfolio losses.

It’s a strategy that tries to smooth out returns and reduce the impact of adverse market movements.

At the same time, being long VIX to offset adverse moves in the S&P 500 doesn’t always have a perfectly inverse correlation.

So the hedge quality may not be perfect.

Correlation Between VIX and the S&P 500

The inverse relationship between the VIX and the S&P 500 is well-documented.

When the stock market declines, fear and unknown often rise, leading to higher volatility expectations reflected in the VIX.

This negative correlation makes VIX instruments fairly effective against equity market risk.

But this relationship isn’t perfect, and there are periods when the VIX and the S&P 500 move in the same direction.

We can see from the graph below that using monthly data there’s a -0.78 correlation between VIX short-term futures and the S&P 500.

For longer-term futures, the negative correlation is even less tight because longer-term readings tend to be more stable and less reactive to what’s going on right now.

Traders need to understand that hedging strategies involving the VIX may not always perform as expected. 

Risks and Considerations

Contango and Backwardation in VIX Futures

Contango and backwardation refer to the shape of the futures curve and have significant implications for VIX futures and related instruments.

In contango, futures prices are higher than the spot price, leading to potential losses when rolling contracts forward.

This is common in VIX futures due to the cost of carrying volatility.

Backwardation occurs when futures prices are lower than the spot price, which can benefit investors rolling over futures contracts.

Understanding these concepts is important when trading VIX futures or investing in VIX ETFs and ETNs, as they impact returns over time.

The Volatility Risk Premium

The volatility risk premium is the tendency for implied volatility to exceed realized volatility over time.

This phenomenon means that selling volatility, such as writing options or shorting VIX futures, can be profitable most of the time.

Nonetheless, the risk of large losses during volatility spikes makes this strategy risky.

It’s often colloquially referred to as picking up nickels in front of a steamroller – you make small gains consistently then lose it all (and sometimes more) during brief episodes when volatility spikes.

Traders exploiting the volatility risk premium have to manage risk carefully, using strategies like spreads or hedging positions.

They should also be prepared for periods when the premium shrinks or reverses, leading to potential losses.

Liquidity and Execution Risks

Trading VIX instruments involves liquidity and execution risks.

Some VIX futures contracts and options may have lower trading volumes, leading to wider bid-ask spreads and potential slippage.

This can affect the cost of entering and exiting positions, especially for larger trades.

Traders should understand the liquidity of the specific instruments they plan to trade and consider using limit orders to control execution prices.

Conclusion

VIX index strategies offer ways for traders to manage risk and capitalize on market volatility.

From trading VIX futures and options to using ETFs and ETNs, these strategies can improve portfolio performance when used appropriately.

Hedging with the VIX can protect against market downturns, while speculative trades can profit from anticipated changes in volatility.

These strategies nonetheless come with complexities and risks, including backwardation/contango (“roll”) effects and liquidity concerns. 

Leveraging VIX index strategies thoughtfully can enable traders to navigate volatility with greater confidence and potentially improve/protect their returns.