We see the VIX mentioned often in the financial media and blogospere, where it’s often referred to as the “fear gauge” or pulled up on the screen to show just how scary of a market drop it was on such and such a day, as evidenced by the spike in the VIX.

But while most of us are using the VIX as a metric to measure asset classes, others are treating it as a unique asset class in its own right, designing investment strategies around the futures and options which are tied to the CBOE’s VIX index.

So who are these hedge funds using the VIX this way, and how exactly do they trade volatility instead of protecting against it? We invited CBOE Director of Education to talk the fundamentals of VIX Futures and Options, then moderated a panel of four professional managers who managing millions trading VIX Futures and Options.

Here’s what this volatility brain trust had to say about VIX Futures, Options, and Volatility.


[drizzle]What is the VIX, really?


For those that like a more visual representation, here’s the VIX charted alongside the S&P 500, where you can clearing see some spikes during S&P down moves.

2016-price-action(Disclaimer: Past performance is not necessarily indicative of future results)

You can’t trade the VIX, but you can trade VIX Futures…

It’s a little crazy, with the VIX an index based on prices of derivatives (SPX options) of an index of securities, but there are derivatives on this index of derivatives of an index called VIX futures (maybe they should be called trivatives or quadriviatives). Here was Rhoad’s overview of VIX futures:


Market Structure:

That last line about the price behavior of VIX Futures being unique is what makes this such an intriguing space for many. Like other future markets, there’s a difference between the spot price of the underlying asset (the VIX) and the futures price in the various contracts. But unlike many other markets, there’s a relentless bid for just one side of that spot price, with a tendency for an asymmetric rise in that demand when and if stock prices start to fall. Here’s Rhoad’s charting the SPX put to call volume to help explain this unique market structure.

cboe-volatility-index(Disclaimer: Past performance is not necessarily indicative of future results)

If we consider the market has an even chance of being up or down over the next 30 days, and if all investors were efficient and rational, the chart above shouldn’t exist. The ratio would cluster around 1.00, with about the same number of bets on prices going up as on them going down. But we don’t live in that world, we live in a world where trillions of dollars of money under management by wall street and mom’s and dad’s on main street are petrified of a big stock market drop, and thus buy up protection (in the form of puts) on those stock portfolios – to the tune of about twice as many puts bought as calls, on average.

That’s all well and good, people need insurance and peace of mind.  But what does that do to the derivatives of the index of derivatives – the VIX futures. It creates a ‘market structure’ where the normal price movement is starting high at the beginning of each contract (reflecting the overpaying of protection by millions of investors), and falling to the spot price of the actual volatility over the next 30 days.  Think of it as a short option proxy, with the time and volatility decay of options baked into the pricing of the VIX futures, and thus the futures price decaying the closer you get to expiration of the contract.  Check the price action of VIX futures in July, Aug, and Sep of this year to see this clearly in play.

vix(Disclaimer: Past performance is not necessarily indicative of future results)

Beware VIX tracking ETFs and ETNs

This market structure leads to a long term VIX position being negative, via paying the roll yield contract after contract, exiting when prices are low and buying back in when they’re high. Just look at the various VIX ETFs and ETNs for proof of that.  And don’t forget to check the inverse VIX play as well, which lags the others unexpectedly not being the inverse of what they do (because there are sharp spikes and times when this market structure doesn’t hold up for a full cycle).

vix-etns-and-etps(Disclaimer: Past performance is not necessarily indicative of future results)

Now, this general discussion on how the VIX works oversimplifies things a bit. It’s not as simple as just selling the VIX futures and collecting that roll yield. Remember those nasty VIX spikes plastered all over CNBC when there’s a market sell off? They’ll rip your (investor) face off if in a simplistic short VIX position. Of course, just buying the VIX and hoping to cash in on the spikes doesn’t seem to work either, as evidenced by the nasty downwards sloping VIX trading ETFs.

Tomorrow, we’ll cover what the managers who actually trade this stuff do to balance these forces out.