Volatility is simply how far a price moves, referred to as variance, over time. By comparing the volatility of one asset to another, we can see which ones potentially pose more risk. In trading, risk is typically associated with downside moves, so volatility when stocks (or other assets) decline is of greater concern to investors than prices spiking wildly higher. Multiple products have been created that appreciate as downside volatility increases. The VIX index is a great gauge of volatility, and multiple products can be traded based on the VIX, which provides traders with a hedge against volatility and additional ways to potentially make money.
What Is Volatility?
How far prices move over time affects investors. If a $50 stock moves on average $1 per day, it is moving about 2% per day. A $50 stock that sees $10 fluctuations in a day is moving 20% per day. The former is likely to be viewed as safer, or at least less risky, than the second stock.
Keep in mind that if a stock is trading at $50 and jumps to $60 in one day, most investors won’t mind, but if the stock drops from $50 to $40 this makes investors very nervous. So when it comes to how volatility is assessed in terms of securities, a price move lower is the volatility investors are generally more concerned about.
Since most investors buy stocks, and don’t short them, if stock prices rise they are happy. But if stocks prices fall, this is interpreted as “bad” volatility and they may wish to utilize a product that helps protect them against those moves lower – downside volatility.
Be sure to read about the Best Investments of All Time
What Is the Volatility Index (VIX)?
The CBOE Volatility Index was introduced in 1993. VIX futures began trading in 2004 and VIX options became available in 2006.
Escalating volatility, at least the downside volatility that scares investors, is often a sign of market turmoil, unrest in the markets, falling stock prices and/or lack of investor confidence. The VIX reflects this; when stock prices fall the VIX rises, acting as a “fear gauge”. It gives a reading of how much uneasiness there is in the market.
When stock prices are rising, fear is low and investor confidence relatively high, so the VIX will usually be at low levels or declining.
The VIX is based on real-time options prices. Options prices, which have a volatility aspect included in their price, tend to increase during periods of market declines. As option prices rise, so does the VIX. When there is little to worry about in terms of volatility (stock prices are rising), option prices on the whole tend to decline, and so will the VIX.
Trading the VIX with Options
Aside from the trading the VIX directly with a VIX futures contract, traders can also trade options on the underlying VIX futures. VIX options (and futures) are offered by the CBOE and can be traded by anyone with a brokerage account approved for options trading.
VIX options expire on the third Wednesday of each month. Quotes (delayed) are available on the CBOE website:
The quotes table lists what the option is called, as well as last sale, current pricing and volume information.
There are options available with expiries up to six months out from the current date. This gives traders some flexibility in choosing a maturity.
VIX1416G10-E (top of the list) means it is based on the VIX futures, expiry in 2014, on the 16th of the month, in month G and has a strike price of $10. Month G is equal to July. H is equal to August and so on. Names for Puts are structured in the same way, except that different letters are used for the expiry, for example S is for July, and T for August.
Strategies with VIX options range from the very simple to the complex. If you believe that stocks may see a significant decline over the next couple months, buy a VIX call option with an expiry a few months out. If stocks do in fact decline, the VIX will rise, hopefully by enough to make your VIX call worth some money. This approach can also be used as a short-term hedge against market declines when holding a portfolio of stocks.
If your view is the opposite—you believe stocks will rise and the VIX will fall – purchasing a VIX put option will give you the potential to profit if this scenario plays out.
Another approach it to look for historical extremes in the VIX index, and attempt to profit when these extremes occur. In Figure 2, between 2007 and 2014 a reading above 40 marked an extreme high in the VIX. Buying puts on the VIX when the price began to decline from these extremes could have been one way to potentially profit as the VIX returned to more normal levels. The downside is that these extremes can last longer, or extend further, than we think, as seen in 2008.
Options expire, so VIX options traders not only need to pick the right direction, but also make their trade at the right times. CBOE VIX options are also typically European style, meaning they can only be exercised on the expiration date, unlike equity options, which can typically be exercised at any time before expiry.
Be sure to read Options 101: American vs. European vs. Exotic
The S&P 500 and the VIX also don’t move in a perfect inverse relationship. From 2000 to 2012 the two indexes moved opposite each other about 80% of the time, according to the CBOE. Therefore, a decline in the S&P 500 doesn’t always equate to the rise in VIX, or vice versa. Although sustained rises or falls in the S&P 500 will cause an overall inverse move in the VIX.
Trading the VIX with ETFs
Trading the VIX is relatively straightforward for stock traders with the advent of exchange traded products (ETPs). These are instruments that are offered on NYSEARCA stock exchange, trade in a similar fashion to stocks and can be bought and sold actively.
Top VIX-Related ETPs Based on Average Daily Volume as of July 9, 2014:
iPath S&P 500 VIX Short Term Futures ETN
VelocityShares Daily 2x VIX Short Term ETN
VelocityShares Daily Inverse VIX Short Term ETN
ProShares Ultra VIX Short-Term Futures ETF
iPath S&P 500 VIX Mid-Term Futures ETN
- VXX is the most actively traded VIX-related ETP. It has an ETN structure, was established in 2009 and has a 0.89% expense ratio. It will typically move inversely to the S&P 500.
- TVIX is a leveraged product, and will therefore move approximately twice as much as VXX. It has an ETN structure, was established in 2010 and has an expense ratio of 1.65%. It will move inversely to the S&P 500.
- XIV is an inverse VIX ETN, which means it will typically move in the same direction as the S&P 500, and in the opposite direction of VIX. It was established in 2010 and has a 1.35% expense ratio.
- UVXY is an ultra, meaning it will move twice as much as the underlying VIX contracts it holds (similar to TVIX). It is structured as a commodity pool, holding multiple assets in the fund. It was established in 2011 and has an expense ratio of 0.95%. It typically moves inversely to the S&P 500.
- VXZ is an ETN based on medium-term VIX futures contracts, and will therefore be slightly less volatile than the short-term VIX futures ETNs (such as VXX). It was established in 2009 and has a 0.89% expense ratio. It typically moves inversely to the S&P 500.
These VIX-related ETPs, as well as a number of others that are available, offer investors ways to pinpoint how they want to trade volatility. There are leveraged ETPs, which give double exposure, useful for hedging large amounts of a stocks with a small VIX related position. Also there are various “expiry” ETPs; VIX-related ETPs based on longer-term VIX contracts will be less volatile than ETPs based on shorter-term VIX contracts.
While VIX-related ETPs are easy to make trades in if you have a brokerage account, there are some drawbacks. These ETFs typically way overshoot the corresponding move in the S&P 500. For example, a 1% drop in the S&P 500 may equate to a 3% rise (or something similar) in VXX. This can make precisely tuning a hedging strategy difficult.
Also, these products are not long-term investments, and are primarily meant for only short-term trading purposes. In the ETPs that move inversely to the S&P 500 there is long-term downward bias, making a buy and hold strategy in these products a bad choice.
The Bottom Line
Volatility is the measure of variance in price over time, but since investors don’t worry about prices going higher, volatility is usually only a concern when prices are dropping. The fear caused by dropping stock prices typically results in sharp moves, lack of investor confidence and rising volatility and VIX readings. VIX options are one way to trade fluctuations in the VIX. Payoffs can be big, but timing needs to be excellent as the options are European style.
Exchange traded products listed on the stock exchange are another way to profit from, or hedge against, volatility. While it is easy to enter and exit trades, the VIX and S&P 500 don’t always move exactly opposite, which can make fine-tuning a precise hedging strategy difficult. ETPs that move inversely to the S&P 500 also have a long-term downward bias, which means—like options—they should be used for short-term trading purposes only.
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