VIX stands for the Chicago Board Options Exchange's (CBOE) Volatility Index. In essence, the VIX is a quantitative measure of how much the prices of the stocks that make up the S&P 500 Index are expected to move up or down in the near future. The magnitude of such swings is referred to as market volatility. Trading the VIX allows you to turn your expectations about future volatility levels into profits and can open up new possibilities to take positions in the financial markets.
The VIX was first developed in 1993, with the formula changing significantly in 2003. While the precise mathematical formulation is quite complex and requires an in-depth understanding of implied volatility, the basic idea is simple. The price at which option contracts change hands depends on future volatility. The CBOE tracks the prices of various stock and index options to calculate where investors expect volatility in the stock market to be over the next 30 days. Since this volatility is indirectly derived from option prices, it is referred to as implied volatility. The results are published every day and known as VIX.
The concept of buying VIX may sound strange, since there is no physical product to change hands. One idea is futures contracts, which are simply legal agreements to buy or sell something at a future date. By using a formula instead of a physical product, a futures contract can be used to buy or sell essentially anything. Say VIX is 100 right now. If you think it'll decline to 95 and another investor thinks it'll be at 105 in a month, you can enter into a futures contract in which you pay the other investor $1,000 for every point the VIX is above 100 in a month. If the VIX is below 100, the other investor will pay you $1,000 for each point below the benchmark.
While futures contracts allow investors to invest in the VIX, they are not as convenient as buying and selling stocks. For one, your broker often requires you to apply for futures trading privileges. In addition, the futures market has a number of technical intricacies which you must study. To further simplify VIX trading, investment banks have introduced VIX-linked exchange-traded funds (ETFs). An ETF trades in the stock market and can be bought just as easily as any other stock. The daily price of a VIX ETF mimics that of a position in the VIX futures market, and holding an ETF will result in the same profit or loss as holding VIX futures.
The World of Volatility
While betting on volatility has become easy and convenient, investors should not embark on this adventure before thoroughly familiarizing themselves with the unique trading strategies required to survive in this unusual market. First of all, increased volatility can result from both good and bad developments in the broader economy. A market crash that drags down stocks or a rally that lifts share prices can result in an equal degree of increased volatility and similar profits for the trader. To reduce losses, volatility traders use hedging strategies involving pairing ETFs with futures or stock options. Such strategies can require advanced quantitative skills and experience.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.