Unlike the S&P 500 or Dow Jones Industrial Index there’s no way to directly invest in the CBOE’s VIX® index. Some really smart people have tried to figure out a way, but there’s just no way to do it directly with something like a VIX index fund. Instead, you have to invest in a security that attempts to track VIX. None of them do a great job. The rest of this post discusses going long on volatility, if you think volatility is going to go down see Going Short on the VIX.
For the average investor there are five ways to go long on VIX:
Buy a leveraged exchange traded product (ETP) that tends to track the daily percentage moves of the VIX index. At the moment the best of these from a short term tracking standpoint is ProShares’ UXVY and Citigroup’s CVOL. VelocityShares’ TVIX is also popular, but it has a persistent tracking error of around 2%.
Buy Barclays’ VXX (short term) or VXZ (medium term) Exchange Traded Note (ETN) or one of their competitors that have jumped into this market. See volatility tickers for a full list of volatility ETN/ETFs. For more on VXX see How Does VXX Work?
Buy VXX or VXZ call options ( ProShares VIXY and VIXM have options also)
Buy UVXY options (2X leveraged version of the short term rolling futures index used by VXX)
Buy VIX call options / short VIX put options
The first two choices are not for the faint of heart. VIX’s moves are often extreme, so if you bet wrong you can lose money in a big hurry (think 15% or more in a 24 hour period), of course there is the equivalent upside if you get it right. In my opinion these are tools for day traders that stay stuck to their screens and have have an excellent sense for market direction. Unless the market is in a sustained high fear mode (e.g., Aug 2011 through Oct 2011) these funds will often erode dramatically over a multi-day period. But if you are looking for the best ETN/ETF to track the VIX short term moves this is as good as it gets.
Unlike CVOL and TVIX, ProShares’ UXVY, is an Exchange Traded Fund (ETF), not the more typical ETN. The good news is that the financial backing of an ETF, unlike an ETN is not dependent on the credit worthiness of the provider because they are guaranteed to be backed by the appropriate futures/swaps. The bad news is that those futures change the tax status of the fund to be a section 1256 fund—which requires filing a K1 form with your tax returns. Typically this is not a big deal, but requires a little extra work.
While these funds do a respectable job of tracking the VIX on a daily basis they will not track it one to one. These funds are constructed using VIX volatility futures that aren’t constrained to follow the VIX—sometimes they are lower than the VIX, sometimes higher. The VIX index tends to drop on Fridays and rise on Mondays due to holiday effects in the SPX options underlying the VIX—the VIX futures don’t track these moves and hence the ETPs don’t track them either.
The second choice, buying non-leveraged volatility ETNs like VXX, is not as twitchy, but be aware that the VXX will definitely lag the VIX index (think molasses), and it is also not suitable as a long term holding because the VIX futures that the fund tracks are usually decreasing in value over time. This drag, called roll loss occurs when the futures are in contango. It usually extracts 5% to 10% a month out of VXX’s price. Proshares has an ETF version,VIXY, that tracks the same index as VXX—if you’d rather use an ETF for playing the VIX this way.
Some VXX closing values compared to the VIX index:
Its first day of trading, 30-Jan-09, VXX closed at a reverse split adjusted 1673.28, the VIX index closed at 44.95
December 2009 VXX had dropped to 608, a 63% decline, compared to the 50% drop in the VIX index value to 22.
8-September-2010, VXX closed at 308, VIX at 23.25.
12-January-2011, VXX closed at 133 v.s. a VIX value of 16.24.
9-March-2012, VXX closed at 88.96, VIX at 17.11
6-February-2013 VXX closed at 23.55, VIX at 13.41
VXX since inception vs VIX index
This is a substantial tracking error. Given its dismal track record it is surprising that VXX usually trades over 50 million shares a day. I think the allure comes from its reliable negative correlation with the equity markets (-3x). If SPY has a significantly down day, you can be pretty confident VXX will have a good day—unlike some investments like gold.
On June 1st 2010 options on VXX were introduced and became almost immediately successful. I think retail investors flocked to them because they lacked most of the VIX option eccentricities—such as European exercise, different expiration dates, VRO based settlement values, and greeks that are generally wrong. VXX options have VXX as the underlying, which avoids the perpetual confusion associated with VIX options where volatility futures are the actual underlying not the VIX index. VXX weekly options are also available.
UVXY options are quite expensive due to the volatility of the ETF, but if want to increase your leverage, or reduce your capital exposure they are a possibility.
The fifth option, buying VIX options, is no more difficult than buying equity options. Unfortunately they too lag the VIX index because they are also tied to VIX futures, not the VIX index. In addition to their sluggish performance, they have these other issues:
The bid / ask spreads are huge! Never pay what is offered, use limit orders and split the bid/ask prices (e.g., if the spread is 3.40/3.80 and you want to buy, offer 3.60 or 3.70 with a limit order.) More on trading VIX options here.
The VIX options are European exercise, unlike most equity options—practically this means the VIX options will predictably match (approximately) the VIX index, only once a month—the moment they expire.
The posted greeks (delta, gamma, etc.,) are almost always wrong. See more here.
Like all options, their premium value erodes with time, especially as you approach expiration.
If you want to trade the VIX you are probably hoping to speculate on its big swings, or you are trying to hedge your portfolio against big, sharp declines. If you want to speculate, be prepared to move in a hurry—the VIX drops quickly once the market angst subsides. Most of the action is over in a few days. If you want to hedge over the longer term I’d avoid these securities and look at long term solutions like Barclays’ VQT, Powershares’ PHDG, or VelocityShares’ SPXH and TRSK. Being long volatility is very expensive if you are trying to get enough leverage to protect a significant portfolio.
As much as possible I try to trade in my IRA accounts—in order to defer taxes of course. It is a bit counter intuitive to be doing more speculative activities in a retirement account, but this approach supports my goals:
Achieving good returns
With reasonable risks
While compounding growth
If your money is in Roth accounts, all the better, but most people interested in trading in their IRAs are restricted to traditional IRAs.
There are restrictions on what trades you can do in an IRA account. For example you can’t short a stock in an IRA account, but option restrictions have eased some over the years, and market innovations like short ETFs (e.g., SH, SDS) have effectively bypassed some of the more onerous restrictions. Brokers vary in what they allow in IRA accounts, so pays to ask around. Fidelity for example allows me to do some types of equity option spreads, while Schwab does not. Covered calls and protective puts on long positions are broadly available within IRAs.
Unlike the S&P 500 or Dow Jones Index there is no way to directly invest in the VIX index. I’m sure some really smart people have tried to figure out how to go long or short on this computed volatility index, but currently there’s just no way to do it directly. Instead, you have to invest in a security that attempts to track VIX. None of them do a great job of this. I’ve given a short answer and a long answer below on how to best short the VIX given the current choices. Take your pick.
Buy VelocityShares’ ZIV inverse medium-term volatility. This product follows general volatility trends, but doesn’t have the neck snapping moves of the short-term based products. You definitely still want to exit if the market volatility starts climbing, but you have more time to react. In the post Timing Inverse Volatlility with a Simple Ratio I provide a straightforward method to time your ZIV entries / exits.
XIV & SVXY attempt to match the opposite percentage moves of VXX. Since VXX only manages about 50% of the VIX’s percentage moves you should expect XIV to have a similar behavior. For more on XIV see this post.
The current set of securities that attempt to track or provide the inverse of the VIX index include:
Volatility futures contracts (CBOE VIX Futures)
Options on volatility contracts (CBOE’s VIX options)
VXX & VXZ ETNs with theirVelocityShares, ProShares, and UBS investment bank competitors (rolling blends of futures contracts that trade like stocks). See this post for a complete list. See How to short VXX for specifics on shorting VXX.
Options on VXX, VXZ, UVXY, SVXY
Inverse funds that attempt go up when volatility goes down
VelocityShares’ XIV ETN (goal—daily short term inverse returns). Looks like a good vehicle for this. More info here.
ProShares’ SVXY ETF (goal—daily short term inverse returns). This is the only Exchange Traded Fund (as opposed to a Exchange Traded Note) in this area.
VelocityShares’ ZIV ETN (goal—daily medium term inverse returns). More info here.
Barclays’ IVOP ETN (short of VXX that started trading 16-Sept-2011). More info here. Not Recommend—low leverage.
Barclays’ XXV ETN (short of VXX that started trading 19-July-2010). Not recommended—very low leverage. More info here.
CVOL (leveraged blend of futures contracts plus short S&P500 position). More info here.
All of these choices can be at least theoretically used to bet that the VIX index will go down. Futures contracts or VXX can be shorted, VIX or VXX puts can be bought, or calls shorted, and XIV can be bought directly.
All of these choices have significant problems.
None of them track the VIX index particularly well, they tend to lag the index considerably
VXX can be hard to short (Schwab has had it in their “Hard to Borrow” category for a long time) and you can’t short stocks / ETFs/ETNs in an IRA account. Fortunately XIV, SVXY, and ZIV are available,
Long VIX / VXX options have serious time decay issues—if the VIX doesn’t drop when you expect your positions bleed money.
Because volatility products are relatively volatile the premiums on options tend to be expensive.
Unhedged short positions leave you exposed to losses larger than your initial investment if you forecast incorrectly. Your losses if the index spikes won’t be unlimited because nothing goes up infinitely, but it could be enough to really hurt. Even the lethargic VXX managed rallies of around 2X in 2010 and 2011.
On the positive side of betting that the VIX index will go down, the VIX index and all of its proxies show mean reversion. After it spikes up, fear always subsides, and any surviving short position would reduce its losses over time and potentially turn profitable—assuming you didn’t get in when the VIX index was really low.
Better yet, short positions on VXX or similar products will also profit from the contango associated with the volatility futures these products are based on.
If you decide you want to go short on the VIX index, I think it makes sense to limit your potential losses if volatility spikes, either with stop loss orders, or with VIX or VXX OTM calls that would really kick in to limit your losses. Stop loss orders are scary because if the market is gapping you might lose quite a bit more than your stop loss order would suggest. For example if you are short VXX at 40 and your stop loss is set at 42, your order might fill at 44 if the market gaps down significantly at opening. The type of stop loss order that becomes a limit order rather than a market order when triggered prevents this scenario, but opens you up to an even worse loss if volatility continues to spike and never trades at your limit price.
Even though it is scary, I think a stop loss order would probably work well. At least looking back over the last couple of years, including the flash crash, the market was orderly enough to prevent large losses if reasonable stop loss orders had been in place.