One of the many great side effects to the rise in popularity of Exchange Traded Funds, ETF's, is that they have increased the types of investments individuals can buy into. The average investor can now easy buy and sell funds that hold actual commodities, indexes, bond portfolios, and even dabble in the options markets without ever making a signal put or call trade themselves.
Today, I would like to point out how investors can use ETF's to play the S&P 500 Volatility Index or VIX.
But, before we get into the ETF's that allow you to profit from the VIX's moves, let take a look at the VIX itself and what causes it to move in one direction or the other. The VIX is calculated using option pricing. It looks at the price of the call and put options because we know that higher option prices mean that investors believe there is a greater chance of volatility. Without getting into too much detail about options, the reason this works is because if an underlying security has high volatility it can make an option more or less valuable depending on what side of the trade you are on. Because the level of volatility will change the likelihood, the option will expire in or out of the money.
Are you confused yet?
Now it gets a little easier. The VIX takes all the information from the Chicago Board Options Exchange and plugs it into a number, which is quoted as a percentage. That number then tells investors the expected movement (with a 68% probability) of the S&P 500 Index over the next 30-days. For example, if the VIX is reading 15, it implies that there is a 68% chance that over the next 30 days, the S&P 500 will not move up or down by more than 15%. On a side note, the VIX is currently trading at about 15.
During times of high fear, uncertainty, worry and concern about what the markets will do, the VIX will rise to say 59.89 as it did on September 30, 2008 (the VIX's peak during the financial crisis). When the economy is moving along and there is very little uncertainty, fear and worry, the VIX will fall lower than it currently is, but rarely falls below 11.
So how do you make money trading the VIX?
First you have to determine what events; market, economic, political, weather, etc. are going to either increase or decrease the volatility of equities. Once you figure out those events, you buy or sell different VIX tracking ETF's depending on which way you believe the volatility of the markets is going to move.
Two of the most common and well known VIX ETF's are the Velocity Shares Daily Inverse VIX Short-Term ETN (XIV) and the iPath S&P 500 VIX Short-Term Futures ETN (VXX). The XIV currently has assets under management of more than $1.3 billion while the VXX has $865 million. Both have rather high expense ratios of 1.35% and 0.89% respectively when compared to other ETF's, but that is due to their uncommon or unique offering to investors. The main difference between the two funds is that, as it states in the name, the XIV is an inverse VIX fund while the VXX is not. This means that the two ETF's move in opposite directions, depending on which way the VIX is moving.
The VXX will move lock-step with the VIX on a one-day basis. Over the past month, the VXX is down 21.68% while the VIX is off by 20.19%.
But, since the XIV is an inverse product, it will move in the opposite direction of the S&P 500 VIX. For example, over the past 30 days the Volatility S&P 500 Index (VIX) is down slightly more than 20%, but the XIV is up just less than 20%. Over a longer period of time, three months, the VIX is up 19% while the XIV is down 36%.
It should be noted at this point that the volatility ETF's are leveraged products and will only correctly track an index for a one day period, over longer terms than one day, the ETF will lose value due to the cost of gaining leverage exposure. This explains the percentage differences in both the one month and longer time periods of both the XIV and VXX when compared to the VIX.
Lastly, nearly all of the volatility ETF's are not ETF's, but ETN's which stands for Exchange Traded Note. The difference between an ETF and ETN is that ETF's hold the underlying assets that make up an index while the ETN's don't hold the underlying assets, buy instead buy others assets that track a particular index. The advantage to the ETN is that they don’t have index tracking errors or at least they are much smaller than what ETF's typically display. Besides that, ETF's and ETN's are nearly the same, especially when it comes to trading them.
So, the next time you believe a major event is going to move the markets or change investors opinions on where the markets are heading remember you may be able to make some money from the event simply by buying or selling the ETF's that track the VIX.
Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This contributor did not hold shares of any company mentioned above. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
