Can You Trade the VIX? Methods for Gaining Exposure

Market volatility represents the degree of price fluctuations in an asset or index. The Cboe Volatility Index, known as VIX, gauges expected market volatility. While the VIX itself is not a directly tradable asset, various financial instruments allow investors to gain exposure to its movements.

Understanding the VIX Index

The VIX is a real-time market index that captures the market’s expectation of 30-day forward-looking volatility of the U.S. stock market. It is calculated and disseminated by Cboe Global Markets, often referred to as the “fear index” because it tends to rise during periods of market stress or uncertainty. The index is derived from the real-time, mid-quote prices of a wide range of S&P 500 Index (SPX) call and put options. By aggregating the weighted prices of these options across various strike prices, the VIX estimates the implied volatility of the S&P 500 over the coming month.

It is crucial to understand that the VIX is an index, similar to the S&P 500, and therefore cannot be directly bought or sold like a stock or commodity. Its value represents a theoretical measure of expected volatility, not a physical asset or a company share. Financial products designed for VIX exposure are derivatives that track its anticipated future values.

Methods for Gaining VIX Exposure

Exposure to VIX movements is achieved through specialized financial instruments. These instruments are designed to reflect changes in VIX values, allowing participants to express views on future market volatility. The primary avenues for gaining VIX exposure include VIX futures, VIX options, and Exchange-Traded Products (ETPs).

VIX Futures

VIX futures contracts represent an agreement to buy or sell the VIX at a specific price on a future date. These contracts are cash-settled, meaning that upon expiration, profits or losses are settled in cash. VIX futures reflect the market’s estimate of the VIX’s value on various expiration dates, extending several months into the future. Monthly and weekly expiration cycles are available, providing flexibility for different time horizons. These futures are commonly used for both speculating on volatility changes and hedging existing equity portfolios against potential downturns, given the VIX’s historical inverse relationship with the S&P 500.

VIX Options

VIX options are derivative contracts that provide the right, but not the obligation, to buy or sell VIX futures contracts at a predetermined price by a specific date. It is important to note that these options are on VIX futures, not directly on the spot VIX index. Like VIX futures, VIX options are cash-settled upon expiration. VIX options are European-style, meaning they can only be exercised at their expiration date, though they can be bought or sold before then.

Exchange-Traded Products (ETPs)

Exchange-Traded Products (ETPs), which encompass Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs), offer a more accessible way for general investors to gain VIX exposure through standard brokerage accounts. These products are designed to track VIX futures indices. The most common VIX ETPs hold a basket of VIX futures contracts, typically focusing on the nearest-term futures.

While both ETFs and ETNs provide exposure to VIX futures, their structural differences are noteworthy. ETFs are investment funds that hold underlying assets, such as futures contracts, and issue shares that trade on exchanges. ETNs, conversely, are unsecured debt instruments issued by a financial institution, effectively a promise to pay the return of an underlying index. This means ETNs carry counterparty risk, as their value is dependent on the creditworthiness of the issuing bank. Generally, ETFs operate under regulations that often provide more investor protections compared to ETNs.

Unique Characteristics of VIX Products

VIX-related financial products possess distinct operational characteristics and market dynamics that influence their performance. Understanding these features, inherent to their structure and the volatility market, is crucial for anyone considering VIX exposure.

Contango and Backwardation

One characteristic is the concept of contango and backwardation within the VIX futures curve. Contango describes a market condition where VIX futures contracts with longer expiration dates are priced higher than those with shorter expiration dates, resulting in an upward-sloping futures curve. This state is typical for VIX futures, occurring approximately 85% to 90% of the time, especially during periods of lower market volatility. The presence of contango can impact the returns of VIX ETPs and futures positions, particularly when contracts are “rolled” from one expiration month to the next.

Conversely, backwardation occurs when nearer-term VIX futures are more expensive than longer-dated ones, creating a downward-sloping curve. This situation is less common, typically emerging during periods of significant market stress or sharp increases in volatility, as participants prioritize immediate protection. Backwardation often implies that the market anticipates volatility to decrease from its current elevated levels in the future.

Volatility Decay

Another characteristic, particularly for VIX ETPs, is volatility decay. This phenomenon refers to the erosion of an ETP’s value over time, often causing it to underperform the spot VIX index over extended periods. This decay is a structural consequence of how these products maintain their exposure to VIX futures. VIX ETPs typically hold a combination of the nearest-term VIX futures contracts and continuously “roll” their positions by selling expiring front-month contracts and buying the next month’s contracts. In a contango market, where longer-dated futures are more expensive, this constant rolling process can lead to a consistent loss of value. The daily rebalancing mechanism, which adjusts the ETP’s exposure, further contributes to this decay, especially when the underlying VIX futures experience significant price swings.

Leveraged and Inverse ETPs

Some VIX ETPs are designed with built-in leverage or inverse exposure. Leveraged products aim to amplify returns, for instance, providing two or three times the daily movement of a VIX futures index. Inverse products, conversely, are designed to move in the opposite direction of the index they track. These leveraged and inverse ETPs amplify not only the potential gains but also the effects of the structural characteristics, such as contango and volatility decay. The daily rebalancing required for these products can lead to their long-term performance deviating significantly from the simple multiple or inverse of the underlying index’s performance, a phenomenon sometimes called “beta slippage” or “volatility drag.” Consequently, these products are generally considered suitable only for very specific, often short-term, trading strategies.