How to trade the VIX
By Simon Gleadall, CEO of Volcube.
The VIX cannot be traded directly!
As we explained in this introduction (The Fear Gauge – What is the VIX?), trading the VIX directly is not possible because the VIX is simply an index number. In the same way that a price index such as the S&P500 Index cannot be traded per se, nor can any number which is merely a measure of volatility. However, there are a number of ways to gain exposure to VIX or to the volatility which it reflects. In this article we will focus on some of the Exchange Trade Products (ETPs) that claim to offer exposure. These products are variously labelled ETFs (Exchange Traded Funds) as well as ETNs (Exchange Trade Notes). The difference here can be more than just word-play, so understanding the nature of these products is essential.
Trading the VIX via Exchange Traded Products
An Exchange Traded Product allows an investor to purchase shares in a holding company whose sole purpose is to give the investor exposure to a particular asset or basket of assets to which the investor might normally have difficulty obtaining. For instance, a physical gold ETP can allow investors to buy shares in a company whose only aim is to buy physical gold. However, an important distinction needs to be drawn between ETPs that physically hold the underlying assets in which the investor is interested and ETPs that do not physically hold all (or any) of the assets but merely promise to replicate the performance of the assets. For instance, an ETP provider might issue a product that promises to replicate the performance of a price index of precious metals, but without actually holding the physical metals themselves. Instead, it will be up to the issuer of the ETP to guarantee the performance of the ETP relative to the index it claims to track. In many cases, the issuer will track the index using derivatives, such as futures contracts. Sometimes they will use a blend of physical assets (say actual shares in a stock market index) and derivatives (such as futures on an equity index). It is vitally important that the investor of any ETP understands exactly what is behind the ETP. The range is from a 100% asset-backed ETP (an Exchange Traded Fund or ETF) to a 100% unsecured Note (an Exchange Traded Note), which is essentially just a promise by the issuer. All ETPs charge a management fee which is typically an annual %age.
Back then to the VIX. ETPs exist which offer some kind of exposure to the VIX index. However, the issuers of these ETPs are usually faced with the same dilemma as the investor; there is no way to directly trade the VIX. So in order to back the ETP with something tangible, they will typically use futures on the VIX as a proxy for the VIX itself. Regular ETPs on the VIX typically offer to match the daily return on the VIX. Hence, if the VIX rallies by 1% during the day, so too should the VIX ETP. In general, there should be a good correlation between short term VIX futures contracts and the ‘spot’ value of the VIX, so this seems fine and dandy.
Unfortunately there is a rather serious problem with this idea which tends to erode the value of the ETP over time relative to the VIX which it supposedly tracks. Futures contracts expire. If the issuer buys a one-month VIX futures contract to try to match the VIX index, then a month from now this contract will expire and the ETP will once again have nothing behind it to track the VIX. Therefore the futures must be ‘rolled’. In order to maintain a constant exposure to the underlying index, the short term long VIX futures position must be sold and a longer term VIX futures position must be assumed in its place. Sadly, this rolling of futures (selling the near term to buy the longer term) often comes at a considerable cost to the fund. This is because it is very common for VIX futures to be in contango. This simply means that longer term futures are more expensive than short term futures. Intuitively, the ‘normal’ state of affairs is for market volatility to be relatively low; generally speaking markets are calm. But there is often a fear of increased volatility on the horizon. Since high volatility tends to come in fits and starts, periods of low volatility might (rightly or wrongly) be expected to be followed by higher volatility. Whatever the logic, the reality in recent years is that VIX futures have exhibited contango. And for the ETP holder, this has been bad news; every month, the issuer of his ETP is buying futures at higher prices and selling them at lower prices. The differences can be substantially; sometimes several percent per month!
The price graph of iPath S&P 500 VIX ST Futures ETN (VXX) versus the VIX Index makes for sobering reading. From November 2009 to November 2014, the VIX Index fell from around 24.75% to 14%; a fall of 43%. Over the same period, VXX which was supposedly tracking the Index fell over 90%. Serious tracking error. To use an options trading analogy, VXX offers a profile which is to some degree long vega (should profit from increases in implied volatility), gamma neutral but paying theta.
So in terms of trading the VIX Index from the long side, it is very tough to see how simple, ‘long VIX’-style ETPs provide a decent solution. As for leveraged ETPs (which offer multiples of daily changes on the VIX), the problems are often compounded. However, there could still be a case for these products when used as very short term instruments. Remember that, in fairness to the issuers, they promise the daily return on the VIX. Therefore it is perhaps not suprising that the tracking error can be substantial over time frames much longer than a day. If the trader wants to assume a very short term long exposure to the VIX Index, then these ETPs could be a good choice, depending very much on his circumstances. But as long term buy-and-hold vehicles, the case is tough to make.
On the short side, the picture might be a little rosier. Inverse ETPs offer the reverse daily return; if the underlying falls by 1%, the inverse ETP should gain by 1% (for example Velocity Shares XIV). By effectively being short the VIX via an inverse volatility ETP, the investor may benefit from a contango VIX futures curve in precisely the opposite way to which the long VXX holder is punished.
In summary, trading the VIX via ETPs is probably viable on a very short term basis but there are serious concerns about the long term situation. Next we will consider using options to gain exposure to the VIX (Coming soon…).
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