The VIX: Using the "Uncertainty Index" for Profit and Hedging

Volatility is a major factor in equity and option investments, and the Volatility Index, or VIX, created by the Chicago Board Options Exchange (CBOE), has been a popular and closely watched indicator almost from the moment it was launched. Though VIX may or may not be a rigorous substitute for risk, investors and financial commentators nevertheless watch this indicator to measure the tenor of investor attitudes about the market and the likely path of short-term trading. As a financial indicator in its own right, however, it is also possible for investors to use the VIX as a means toward profits or the protection of their portfolios.

The VIX is a weighted index that blends together several S&P 500 index options, with the notion that the greater the premiums on these options, the more uncertainty about the direction of the market. In design, then, it is the square root of the 30-day period returns, and it is expressed as percentage points. As such, it is supposed to be a forward-looking representation of what sort of volatility the markets expect in the short term.

Though VIX is frequently used as a measure of investor fear (or complacency), that is really not what it measures, as consensus optimism or pessimism would not result in an especially high VIX. Accordingly, it should probably be better thought of as the "uncertainty index" (though it is fair to admit that the there is a strong link between fear and uncertainty on the Wall Street). Nevertheless, there is a negative correlation between the VIX and S&P 500 index (meaning that they move in opposite directions).

It is also important to note that the VIX is not technically a direct measure of risk. There is ample debate about what risk really is, and some investors do use past or projected volatility as a proxy for risk. That said, risk should be better thought of as the historical volatility of portfolio movements, not the expected up-and-down swings along the path.

Investors have a variety of choices for incorporating VIX into their portfolios.

ETNs
Exchange-traded notes (ETNs) are one of the most popular ways to trade the VIX. Similar to ETFs, ETNs allow investors to buy and sell instruments designed to replicate certain target indices. In the case of VIX, these ETNs hold a collection of rolling VIX futures contracts.

ETNs are relatively cheap to buy and sell, and any broker can handle the trades. It is important for investors to realize that these are NOT identical to the spot VIX. Moreover, because volatility is a mean-reverting phenomenon, the VIX ETNs can deviate from spot VIX – trading higher than they should during low volatility (on the presumption that volatility will increase) and lower during periods of high volatility.

Investors should also be aware that leveraged VIX ETNs have additional drawbacks. Because of the repositioning that occurs in the portfolio, there is a phenomenon called "volatility lag" that hurts performance. While leveraged volatility ETNs do come closer to replicating the actual performance of VIX, these instruments are really only effective when held for short periods of time (as volatility lag eats away at the returns over time).

See: No Surprise: VIX ETPs Aren't Great Long-Term Ideas.

VIX Futures and Options
More sophisticated investors can also opt to trade options and futures on the VIX index itself. Options and futures offer greater leverage to investors, and so greater return potential on a successful trade. That said, there are some factors that investors should keep in mind. Options and futures often carry higher commissions than equity trades, and futures traders will be required to maintain a minimum margin. Investors should also be aware of different tax treatment on gains and losses, particularly for futures contracts. Options and futures are also investments with a definite lifespan, so not only do investors have to be right about the direction of volatility, but also the timeframe.

VIX options are European-style options, meaning that they can only be exercised upon expiration. What's more, these options expire on Wednesdays (unlike the more traditional Friday expiration for options), and settlements are in cash. While the built-in leverage of options serves to produce magnified returns, investors should note that these options do trade on expected forward value and can deviate from the spot VIX.

In other words, because of the European-style exercise and the mean-reversion of volatility, VIX options will often trade at lower value than what seems appropriate during periods of high volatility (and vice versa in low volatility periods), particularly early on in the term of the option

Like options, VIX futures are inherently leveraged and tend to better replicate the movements of spot VIX than the ETNs. Here again, though, investors should realize that the value of the futures contract is based on a forward-looking assessment of VIX. Actual futures can be lower, higher or equal to the spot VIX based upon that outlook and the amount of time left before settlement.

Additionally, there have been allegations of VIX manipulation, and investors on the wrong side of major moves have taken huge hits. For more, see: Is Someone Manipulating the VIX?

There is no rule that investors must use VIX and VIX-related instruments to trade on the volatility of the markets. In fact, in many cases, VIX instruments may be less than ideal hedges, whether that is because of cost, time horizon, or the differences between a portfolio's beta and the market. For investors who want additional alternatives, certain option strategies may be worth a look.

Strangles/Straddles
Strangles and straddles are one viable way to trade the expected volatility of an index or individual security.

A long straddle strategy means buying a call and put option on the same security with the same strike price and expiration. The maximum loss is the premium paid for the two options (plus commissions), while the potential gain is unlimited and the investor profits as soon as the price moves far enough above (or below) the strike price to clear the premiums and commissions.

To build a strangle, an investor buys a call and put option for the same underlying security with the same expiration, but different strike prices. The primary advantage to using a strangle is that it is cheaper to buy, but a strangle also requires a larger price move to produce a profit.

Simple Puts
If an investor is simply looking to hedge market exposure, a simple index put may be the most efficient option. Puts are available on virtually every major equity index and tend to be quite liquid. Investors need to be careful to calculate their exposure correctly (buying S&P 500 puts to hedge a portfolio that is only loosely correlated with the S&P 500 won't give as much protection, for instance), but puts are a very simple way to hedge against the risk of short-term market pullbacks.

While most investors look to stay away from volatility, others embrace it and even try to profit from it. ETNs may be a good choice for those looking to play a specific feeling about near-term market volatility, while options and futures offer traders more bang for their buck. Given the drawbacks and costs of VIX-related investments, though, investors looking to hedge their portfolios may simply want to consider regular put options as a cheaper alternative.