“VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility”- Chicago Board Options Exchange (CBOE)
You may have heard people and news articles mention the VIX index. It is a somewhat complicated index to understand at first, but when you get into it, you start to realize what a unique index it is and all the things it can indicate in the market. This article is going to focus on understanding what the VIX is, how it is used in the markets, in practice, and of course how you can trade it for some profit – because that’s what this is all for at the end of the day!
What is the VIX?
First of all, let us start with the name ‘VIX’. The VIX stands for Volatility Index and it is made by the Chicago Board Options Exchange. All in all it is the CBOE Volatility Index (the acronym ‘VIX’ is trademarked FYI!)
It has several names such as the volatility index,VIX index, the fear gauge or the fear index. You get the point, it is measuring the risk involved in the markets.
The official definition is that ‘the CBOE Volatility Index is a popular measure of the implied volatility of S&P index options, and is one measure of the market’s expectation of market volatility over the next 30-day period”
Let’s break this down:
The VIX is a weighted blend of prices for a range of options on the S&P 500 index. Now we don’t need to be options masters here, but keep in mind the goal is to estimate the implied volatility for the S&P 500 index over the next 30 days.
We will not go in depth into its valuation and theoretical points here, but rather focus on the application and meaning behind it.
The VIX trades at a price, and this price is actually a percentage point. So if you are looking at a price of lets say 18, then there is a 68% (c’mon now guys – basic standard deviation, 68% is one standard deviation under normal distribution) chance **according to market expectations** of a move less than 18% up or down in the S&P 500 index.
Again, without getting technical on option valuation, the basic idea is that put and call options can be used to measure implied volatility. This is because volatility is actually an input to option calculation. Therefore we can circle back and see the implied volatility of the asset they are based on, in the VIX’s case – the S&P 500.
This chart shows the relationship between the VIX and the S&P 500. You can read more here, but the idea is that over the period, the VIX moved opposite to the S&P 500 Index 80% of the time, showing its strength as an indicator.
Let’s not forget here that just because it is known as “the fear index” this does not imply a downside risk. It implies volatility and that is both positive and negative. You can see this in situations such as the lead up to Brexit where the VIX spiked in response to the first few votes indicating a swing towards the ‘leave camp’. Situations like this are great to play the VIX – if you are making the right calls of course.
You can see the VIX reaction to Brexit below.
ETF’s baby, E….T….Fricking F’s
So how you may ask, do I get in on this volatility action? You can’t directly trade the VIX, but ETF’s are your friend here. Let’s lay down the money here…
These are the ETF’s that track the VIX Index in Canada:
Horizons Betapro S&P 500 VIX Short Term Futures ETF
HUV Attempts to track VIX directly, hedged to CAD so has lost out to some of the upside in the past
Horizons Betapro S&P 500 VIX Short Term Futures Bull Plus ETF
HVU Attempts to double the performance of HUV (above)
Horizons Betapro S&P 500 VIX Short Term Futures Inverse ETF
HVI Attempts to track the opposite of HUV (the normal VIX index ETF)
Some of the ETF’s not listed in Canada include:
Velocity Shares Daily 2x VIX Short-Term ETN
TVIX Twice (2x) the daily performance of the S&P 500 VIX Short-Term Futures Index ER (Bloomberg: SPVXSP).
VelocityShares Daily Inverse VIX Short-Term ETN (XIV)
XIV Linked to the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index ER (Bloomberg: SPVXSP).
You can trade these ETF’s from any brokerage account. You can see our review on the top brokers of 2016 here.
Criticism of VIX
This article is not meant to highlight the VIX index as the “be all to end all” indicator of market volatility, but it is the most well known. Several criticisms of VIX are out there. They are important to keep in mind when doing your research and making a VIX ETF play on the perceived volatility of an event(s).
⦁ VIX is sometimes criticized in terms of it being a prediction of future volatility. It is a measure of the current price of index option
⦁ Some practitioners and portfolio managers seem to completely ignore or dismiss volatility forecasting models
What we are trying to say in a nutshell is this:
The VIX is a highly unique product that can be used to trade events in the world and perceived volatility. The key word here is perceived, and not always what reality actually is – Brexit is a prime example. It is a highly risky trade, especially when using leverage products, but hey, no risk no return eh?
To read a bit more in depth about the VIX and the ETF’s involved, check out this website