What Is The VIX, And What Does It Do?

Between a U.S. president who has a reputation for unpredictability, geopolitical uncertainty in North Korea, Russia and elsewhere and a stock market that is within a stone’s throw of all-time highs, it’s understandable for traders to be a bit leery at the moment.

Headlines of political unrest often trigger periods of elevated volatility in the stock market. While traders may know that the VIX is one of the more common methods of measuring market volatility, they may not all know what exactly the VIX is and how it should be traded.

What Is The VIX?

VIX is a ticker that represents the Chicago Board Options Exchange Volatility Index. The VIX has been around for 23 years and is a measure of the implied forward 30-day volatility of the market. The VIX is calculated by using the at-the-money put and call option prices for certain stocks.

The CBOE describes the VIX as 100 times the square root of the expected 30-day variance of the S&P 500 rate of return. For the average trader, the only important thing to know about the VIX is that it represents the amount of volatility options traders are pricing in over the month ahead.

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Ways To Trade The VIX

Since the VIX ticker is simply a calculation and not an actual asset, traders can’t buy and sell the VIX directly. Instead, they must rely on ETFs and ETNs that are structured to correlate with the VIX. The most common VIX-based ETN is the iPath S&P VIX Short Term Futures TM ETN VXX, but there are a number of other alternatives as well:

• ProShares Trust II VIXY
• Credit Suisse AG – VelocityShares Daily 2x VIX Short Term ETB TVIX
• ProShares Trust Ultra VIX Short Term Futures ETF UVXY
• Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN XIV

A Word Of Warning

Unfortunately, the window for profitability for many of these volatility ETFs and ETNs is very small. Since they are comprised mostly of short-dated futures contracts, the constant roll-over leaves them susceptible to contango, a long-term price decline resulting from futures time value decay. On any given day, the VXX will trade closely in tandem with the VIX, but contango constantly saps the long-term value of these ETFs on a daily basis.

In fact, the VXX is now down 90.4 percent in just the past three years alone. The longer traders hold these volatility ETFs, the lower the probability of success.