Can You Trade the VIX? A Look at VIX-Linked Products

The CBOE Volatility Index, known as the VIX, measures market expectations for near-term volatility. Often called the “fear gauge,” it indicates the anticipated magnitude of price fluctuations in the S&P 500 index. The VIX is a statistical calculation, not a directly tradable asset.

While the VIX index cannot be bought or sold directly, market participants can gain exposure through various financial instruments. These products reflect changes in expected market volatility. Understanding these linked products is key for incorporating volatility into financial strategies.

Understanding the VIX Index

The VIX index represents a real-time market expectation of 30-day forward-looking volatility. It derives from the prices of S&P 500 index options with expiration dates within a 23-day to 37-day window. This calculation aggregates implied volatilities across these options, reflecting the market’s collective forecast of future price swings for the S&P 500.

The VIX value continuously updates throughout the trading day, acting as a barometer for market sentiment. A higher VIX value indicates a market anticipating larger and more frequent price movements, often associated with increased uncertainty. Conversely, a lower VIX suggests expectations of calmer market conditions with less pronounced price changes.

Financial Instruments for VIX Exposure

Several financial instruments provide avenues to gain exposure to VIX movements. These products allow investors to speculate on or hedge against changes in anticipated market volatility.

VIX Futures Contracts

VIX futures contracts are standardized agreements to buy or sell the VIX at a predetermined price on a future date. These contracts derive from the VIX index, allowing market participants to take positions based on their expectations for future VIX levels. The pricing of VIX futures for different expiration months also plays a significant role in price discovery for other VIX-linked products.

Options on VIX Futures

Options on VIX futures offer the right, but not the obligation, to buy or sell VIX futures at a specified price before a certain date. These options contracts can offer leverage, meaning a small price movement in the underlying VIX futures contract can lead to a larger percentage change in the option’s value. Different strike prices and expiration dates allow for varied exposure profiles.

Exchange-Traded Products (ETPs)

Exchange-Traded Products (ETPs), including Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs), are popular vehicles for VIX exposure. These ETPs do not track the spot VIX index directly but aim to replicate the performance of VIX futures contracts or strategies involving VIX futures. Many VIX ETPs focus on short-term VIX futures, holding and rolling over contracts with near-term expiration dates to maintain continuous exposure.

Key Characteristics of VIX-Linked Products

Financial products linked to the VIX have several characteristics that influence their performance. Understanding these features is important for anyone considering these instruments, as they stem from the unique nature of volatility and VIX futures markets.

Contango

Contango is frequently observed in VIX futures markets, occurring when longer-dated futures contracts are priced higher than shorter-dated ones. For ETPs maintaining continuous exposure, this means they must regularly “roll” positions by selling expiring short-term futures and buying more expensive longer-term contracts. This rolling process can create a drag on performance over time, especially in prolonged contango.

Daily Reset Mechanism

Some VIX ETPs utilize a daily reset mechanism, rebalancing their exposure at the end of each trading day. This compounding of daily returns can lead to a significant divergence between the ETP’s performance and the underlying VIX futures index over periods longer than a single day. This effect is pronounced during high market volatility, where daily fluctuations amplify the impact of the reset.

Price Swings and Liquidity

VIX-linked products exhibit extreme price swings due to the inherent nature of volatility. Rapid movements in the underlying VIX index translate into large percentage changes for these products. Liquidity in the markets for VIX futures and related ETPs can fluctuate, potentially impacting the ease of executing trades and filled prices.

Time Decay (Theta)

Options on VIX futures are subject to time decay, or theta. As an option approaches its expiration date, its extrinsic value erodes, even if the underlying VIX futures contract price remains unchanged. This decay accelerates as expiration nears, making it a significant factor for those holding VIX options.