The VIX Explained

Most traders are aware of the VIX and have at least some vague idea what it represents — market volatility. However, in order to trade VIX-based market volatility, traders must first understand how exactly the VIX tracks market volatility and what types of trading strategies can capture that movement.

WHAT IS THE VIX?

VIX is the ticker for the Chicago Board Options Exchange Volatility Index. The VIX was created in 1993 to measure the implied forward 30-day volatility of the market based on at-the-money put and call option prices for a handful of stocks. Since 2004, the VIX’s implied volatility measure has been based on S&P 500 index options.

According to the CBOE website, the VIX is calculated as 100 times the square root of the expected 30-day variance of the S&P 500 rate of return. The CBOE website also includes a full list of the formulas used to calculate the VIX for traders that want to learn more. However, the basic gist of the VIX is that it measures the implied forward volatility of the market based on option prices.

HOW TO TRADE THE VIX

Unfortunately, it’s impossible to buy and sell the VIX since it is just a measure of options prices and not an actual product in itself. Instead, traders can choose to buy and sell VIX-tracking funds and notes, such as the iPath S&P VIX Short Term Futures TM ETN (NYSE: VXX) and the ProShares Trust II (NYSE: VIXY). The VXX ETN, for example, invests in short-dated VIX futures in an attempt to closely mirror the VIX’s daily movement.

However, traders need to understand that the constant rollover of short-dated futures contracts leaves the VXX and similar trading vehicles particularly susceptible to contango, which is a long-term price decline due to futures time value decay. The VXX and other products may move closely in tandem with the VIX on a day-to-day basis, but the ETN is down 90.8 percent overall in the past three years due to contango. The VIX itself is down just 18.2 percent in that same period.

TRADING VIX REVERSION

There are many volatility-based trading strategies, but one of the more popular options is trading mean reversion in the VIX. In theory, the average market volatility shouldn’t increase or decrease over time. That theory has historically held true as, since its inception, the VIX baseline has remained in the low teens during the most tranquil market periods and has not exceeded the high teens through most of the market’s more chaotic periods.

However, when major news events lead to a short-term spike in market fear, the VIX often reacts in kind with large, short-term spikes. Viewing a long-term chart of the VIX reveals that it has drifted mostly sideways for the past 30-plus years, but has spiked repeatedly every time the market gets a case of the jitters.

Mean reversion traders take advantage…

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