Why Trade VIX
There are two big groups of motivations why people or institutions trade the VIX:
Trading the VIX for hedging
Many market participants, especially institutional investors, trade VIX to hedge their long stock portfolios. Because stock market volatility tends to rise when stock prices are falling, the VIX Index is strongly negatively correlated to equities. As a hedging tool, VIX derivatives have several advantages over stock index options (e.g. it's easier to set up and manage a position and you often get the same hedging effect at a lower price with VIX).
Trading the VIX for speculation
In the recent years, in line with increased liquidity and public awareness of VIX Index and its derivatives, VIX has become a convenient pure volatility play, enabling traders to speculate on volatility without having to deal with other exposures (such as delta of?stock index options).
VIX Trading Specifics
When trading the VIX, you should be aware of its specifics, which make it quite different from other markets you might be used to:
- VIX itself is not an asset – it's just a number (like S&P500 and other indexes). It can't be bought or sold. It can't be traded. When you want to trade the VIX, you need to trade its derivatives – futures, options, or ETFs or ETNs based on them. It also means that VIX futures and options are always cash settled, because no physical delivery is possible.
- VIX Index itself can be considered a derivative. Its value is derived from prices (and implied volatility) of S&P500 index options and therefore without the S&P500 index there would be no VIX either. When you are trading VIX, you are in fact trading S&P500 – you are just not trading its price, but the implied volatility of its options. It means that for trading VIX successfully, it is very useful to know S&P500 price and volatility behaviour patterns very well.
- VIX options are European style – they can be exercised only at expiration. This is just like S&P500 index options, but unlike options on individual stocks or ETFs, which are American style and can be exercised at any time before and at expiration.
- VIX futures pricing can't be explained and calculated using a no-arbitrage model, as you can do with commodities or some other futures. This is because you can't hold or go short the underlying?(VIX Index).
- The distribution of VIX value changes is anything but normal. It is strongly positively skewed (positive changes in VIX tend to be less frequent, but greater in size than negative changes). Even when you are not an expert statistician, you can see it when you look at a VIX chart. You see that VIX often stays in the 10-20 range for very long time and then suddenly spikes to 40 or 45. You can also see that it takes the VIX very short time to go up to extremely high values, but it takes much longer for it to decrease back to the original level.
- VIX tends to revert to the mean. It means that when VIX is very low (e.g. 10), the probability that it will rise is much higher that the probability that it will fall. Conversely, when VIX is very high (e.g. 50), the probability of a fall is much higher than the probability of the VIX rising further. Of course, the exact path, timing, and size of the moves are very unpredictable.
- When the VIX Index is very low (e.g. at 10) and you strongly believe that it will go up in the future (as it's very likely when VIX is at 10), it doesn't mean you can simply buy the VIX and wait till it goes up. As already mentioned, you can buy VIX only through buying its futures, options, or related ETFs or ETNs (which also get the desired exposure by buying VIX futures or options). When the spot VIX Index?is at 10, you are not alone in thinking that it will go up. Many other market participants also expect a future rise in VIX and VIX futures and options are priced accordingly. For futures it means that they are in contango – far away contract months are more expensive than near term months – see more info here: VIX Futures Curve. For options it means that VIX calls are priced with high implied volatility. In both cases, you pay for holding a long VIX position (either through the negative roll yield in VIX futures or through time decay in VIX options). This is very typical for VIX derivatives, unless the spot VIX Index is at very high levels (35-40 or more).
Trading VIX Futures vs. Options
So which one is better to trade – VIX futures or VIX options? There is no universal answer, as both have advantages and disadvantages. VIX futures contracts may be too big and too volatile (in short – too risky) if you have?smaller account size. Options, on the other hand, may seem too complex to understand and analyze (as you are dealing with "volatility squared" here – volatility of volatility). I believe that VIX futures and VIX options go hand in hand and it's not a good idea to just focus on one and ignore the other. Even when you are only trading VIX options at a moment, knowing what VIX futures are doing is useful (and vice versa).
VIX Trading Strategies
Some sources of edge when trading VIX
- The mean reverting nature of VIX. This is a very solid and very consistent phenomenon, but of course you can't trade it blindly. In any case, knowing the statistics and the odds is very useful.
- Seasonal effects – volatility tends to rise in some parts of the year and decline in others.
- Expiration cycle – specific patterns tend to repeat themselves with futures and options expiration cycle.
- Other calendar effects which affect volatility of equity markets, such as the macro data release calendar or earnings season.
- Intraday market patterns – the S&P500 and VIX tend to behave differently during different time periods of a trading day – e.g. morning vs. lunchtime vs. afternoon vs. close.
- Technical analysis – on S&P500 rather than on the VIX itself.
- Fundamental analysis – economic cycle, macroeconomic indicators and their trends.