What is the VIX and how can you trade stock market volatility with VIX ETFs?
VIX ETFs give investors a whole new way to trade and invest in VIX, or the “Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.” The VIX Index is a continuous minute-by-minute snapshot of the expected market volatility in the S&P 500 during the next 30 calendar days and now can be traded using VIX ETFs and VIX ETNs like the Path S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) or the VelocityShares Daily 2X VIX Short Term ETN (NYSEARCA: TVIX).
This volatility is determined via stock index option prices (both calls and puts) and is continuously revised throughout the day due to the fact that stock index option prices are always changing. This volatility is supposed to provide a measure of the market risk that is inherent in the S&P 500 Index, which is why the VIX Index is often known as the “fear indicator.”
The VIX Index that is currently in use is the second version of the VIX Index, which was introduced in 2003. The first version of the VIX Index, introduced in 1993 by the CBOE, was a weighted measure of the implied volatility of eight “at the money” and “near the money” put and call options listed on the S&P 100 Index.
The second version, which is still used today, has two variations from the original VIX Index. The first variation was that the VIX Index now used the S&P 500 Index to determine market volatility, as it was decided by the CBOE that the S&P 500 Index provided a more accurate representation of the stock market than the S&P 100 Index did. The second variation was that a greater number of options was used in the calculation of the weighted average of the VIX Index. This was also made in the name of providing a more accurate representation of the implied volatility that existed within the option premiums on the market.
To calculate the VIX Index, the options that are used are either in the nearest month to expiration (known as the “front month”) or in the second month. This is done because the VIX Index is used to estimate the implied volatility that an S&P 500 “at the money” option would have with 30 days remaining until its expiration.
The VIX Index is a number that is between ’0′ and ’100,’ though it is often at the lower end of that range. The number itself represents the anticipated percentage movement in both directions of the S&P 500 Index over the following 30 days. For example, if the S&P 500 was at ’1400′ and the VIX Index had a reading of ’20,’ the S&P 500 Index would be expected to move within a range of 1.67% (calculated by taking the ’20′ from the VIX indicator and dividing it by 12 months) over the next 30 days. This means that the S&P 500 would be expected to be within ’1376.67′ and ’1423.33′ (plus and minus ’23.33,’ which is plus and minus 1.67% of 1400).
It’s important to keep in mind, however, that the VIX Index is constantly being updated due to the fact that stock prices are continuously changing, thus affecting the implied volatility that is inherent in the S&P 500′s nearest two months’ options premiums. As a result, the S&P 500 Index is not guaranteed to trade within that range predicted by the VIX Index at any given moment.
However, the VIX Index can give you an accurate assessment of the attitude of investors and traders regarding the current market and how they see it progressing it over the coming month. Those who are skilled at reading the VIX Index and assessing traders’ attitudes to anticipate how stock prices will react can use that information to help them make money from stocks and options.
If you wish to trade the volatility of the stock market, you have two ways of doing it. You can either buy volatility call or put options or you can purchase VIX ETNs or VIX ETFs. Although there are VIX ETFs available, most securities which track the VIX Index in some way usually come in the form of VIX ETNs or VIX Exchange Traded Notes. Click here to read more about the differences between ETFs and ETNs.
Volatility call and put options have their values determined by the price and movement that occurs on the CBOE’s Market Volatility Index (VIX Index). Volatility call and put options are recommended only for those who are advanced traders due to the fact that volatility options provide the purest way to take advantage of market volatility, shielding investors from other financial influences that can affect VIX ETNs.
VIX ETNs have their values determined by the price and movement of volatility options that are connected to the movement of the VIX Index. There are both long-oriented and short-oriented VIX ETNs. Long oriented VIX ETNs can be bought when volatility is low (i.e. when the VIX Index is less than ’20′) so that investors can seek profit from spikes in volatility. Short oriented VIX ETNs can be bought when volatility is high (i.e. when the VIX is greater than ’40′) so that investors can seek profits from substantial drops in volatility.
It is important to note that the VIX Index doesn’t just reflect how much volatility is in the S&P 500 Index; the VIX Index also indicates how much options traders are paying for options contracts to protect their investments from downturns in the market.
Some of the most well-known VIX ETNs include:
- iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)
- VelocityShares Daily Inverse VIX Short-Term ETN (NYSEARCA:XIV)
- VelocityShares Daily 2x VIX Short Term (NYSEARCA:TVIX)
- iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ)
- S&P 500 Dynamic VIX ETN (NYSEARCA:XVZ)
(NYSEARCA:VXX) is an unsecured debt security that is issued by Barclays Bank PLC and is designed to track the S&P 500 VIX Short-Term Futures™ Index Total Return. This VIX ETN provides exposure to a daily rolling long position in VIX future contracts’ first and second months, which depends upon the implied volatility of the S&P 500 Index as it moves along the forward volatility curve.
(NYSEARCA:XIV) inversely tracks the S&P 500 VIX Short-Term Futures™ Index Excess Return and reflects the returns that can be earned via an unsecured debt security in short-term futures contracts, which are measured via the VIX Index.
(NYSEARCA:TVIX) is the VelocityShares Daily 2X VIX Short Term ETN and is a financial investment that is purchased to trade volatility on the long side. This investment is designed to gain the returns of twice the daily performance of the S&P 500 VIX Short-Term Futures™ Index.
Bottom Line: The VIX Index is the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the expected volatility of the market over the next 30 days. This is determined by the stock index option prices trading on the market, with this number constantly being revised due to the fact that prices continuously fluctuate throughout the trading period. VIX ETNs offer investors and traders the opportunity to express their opinions regarding the future of the VIX Index and volatility by using either long or short VIX ETNs.