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. The best of these from a short term tracking standpoint is ProShares’ UVXY
- Buy Barclays’ VXX (short term), VXZ (medium-term) Exchange Traded Note (ETN) or one of their competitors that have jumped into this market. Volatility tickers gives investors a full list of volatility ETN/ETFs. For more information on VXX see How Does VXX Work?
- Buy VXX or VXZ call options ( ProShares’ VIXY, VIXM)
- Buy UVXY options (1.5X leveraged version of the short term rolling futures index used by VXX)
- Buy VIX call options / short VIX put options (Thirteen Things You Should Know about VIX Options
The choice is 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 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.
ProShares’ UVXY, is an Exchange Traded Fund (ETF). The good news is that the financial backing of an ETF, unlike an ETN is not dependent on the creditworthiness 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 partnership—which requires filing a K1 form with your tax returns. Typically this is not a big deal but requires a little extra work.
While UVXY does 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 due to the fact that 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.
Volatility Funds vs the VIX
The chart below shows how VXX’s price has fared relative to the VIX. The VIX is a range bound index (scale on the right side of chart) that stays between around 9 and 80, whereas VXX erodes over time and must be reverse split to keep its price in a reasonable trading range.
On this scale, you can see that VXX “tracks” the VIX only in the loosest sense. Given its dismal track record, it’s 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 significant 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 behave much more like the underlying than the VIX. 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 bid / ask spreads can be wide. 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 the longer-term strategy funds described next.
There are two basic volatility strategy categories, one grouping is funds intended as portfolio solutions that combine equities (S&P500) and a volatility hedge. This represented by PowerShares’ PHDG, The other fund, Barclays’ XVZ, is a straight volatility play. Its design attempts to minimize losses when the market is quiet and take make dramatic gains when volatility really spikes.
The downside of these volatility strategy funds is that they sometimes decay anyway, they don’t respond quickly to fast volatility events like overnight scares or flash crashes, and they don’t track daily VIX moves all that well. However, both types of volatility strategy funds should do very well in bear market scenarios, taking advantage of the strong backwardation in VIX futures that occurs during panicky times.
Bottom line, it’s very tempting to try and guess when the VIX will spike, but in practice, most people don’t get the timing right. If you buy options or ETPs like UVXY or VXX you will likely see your money wither away. Consider the volatility strategy funds that I discuss towards the end of this post—they don’t require hair-trigger timing and they should do very well when a true bear market arrives.