In this article, I will discuss the value of investing in the Volatility Index as a hedge. The Volatility Index is officially called the Chicago Board of Exchange (CBOE) Volatility Index, or the VIX Index (aka VIX) for short. The VIX is a real-time market index that tracks the 30-day expected ("implied") volatility of the S&P 500 Index (SPX), using options on the SPX as inputs. The VIX is also a forward-looking indicator of market volatility, and is frequently referred to as the "fear index" or "fear gauge," as the index indicates the degree or expected level of uncertainty in the market.
When the VIX is relatively low, this is an indication of a complacent market. When the VIX is relatively high, this is an indication of greater fear and uncertainty in the market. As this article covers, the VIX, based on past performance and the underlying principles driving volatility in the index, makes trading VIX products a valuable option for hedging against downside stock market risk.
Although the VIX cannot be directly traded, more sophisticated investors seeking volatility exposure can trade futures and options listed by CBOE. Investors can also choose to trade exchange traded funds/notes (ETFs/ETNs) designed to provide direct exposure to the VIX, as discussed in this article.
Introduction to the Volatility Index
The VIX Index is the most popular gauge or indicator for tracking volatility levels in the market.
The VIX price is calculated by CBOE using S&P 500 Index (SPX) option prices that are between 23-37 days to expiration. CBOE uses a weighted average calculation between these expiration cycles to come up with the 30-day implied volatility number, which is represented by the VIX price. In spite of this, the VIX is expressed in percentage annualized one standard deviation (68% probability) move of returns on the SPX.
For reference, the live VIX Index chart can be seen below:
As you can see, between 1990 and 2020, the closing price of the VIX Index has been between 9.14 and 82.69. Naturally, the frequent fluctuation of the VIX causes option prices on the SPX to change often on a day-to-day basis as well.
In general, the VIX has an inverse relationship to the SPX. Therefore, when the SPX rises, the VIX will often react in an opposite manner, and vice versa (but not always).
The VIX price also suggests the degree of market uncertainty:
- Higher VIX Prices (Lower SPX Prices) = More expected uncertainty being priced into the market.
- Lower VIX Prices (Higher/Flat SPX Prices) = Less expected uncertainty being priced into the market.
Higher VIX prices can be explained from increasing option prices during periods of higher market volatility, often times due to greater fear/uncertainty in the market.
If the SPX falls on the next trading day, for example, option prices on the SPX will typically rise because more investors are hedging their position, with more investors being willing to pay a higher premium for their options. This is simply because these option investors are expecting the market to be more volatile (and potentially fall even further), and will purchase SPX options for speculative purposes and/or to hedge risky positions.
Higher periods of market volatility can also increase the chances of option prices hitting their strike prices (the price an option can be bought/sold), which can encourage option investors to close their positions and take a profit. Ultimately, this encourages the pricing of stock options to be higher. Clearly, the prices investors are willing to pay for options will often reflect how much the SPX is expected to move over a particular period.
When the SPX rises or remains flat, the VIX tends to decrease because there’s little need for investors to buy protection (via options) in a hurry, given the rise in stock prices and/or relatively lower volatility.
In summary, investors like to invest in the VIX to hedge their stock portfolio, as the VIX exposure in their portfolio will tend to increase in value while a market selloff may be occurring.
Note that investors familiar with options trading can also use the VIX to determine an appropriate strategy, depending on the current market environment:
- Cheaper Option Prices (Low VIX) = "Long premium strategies." Benefit from increases in implied volatility.
- Expensive Option Prices (High VIX) = "Short premium strategies." Benefit when implied volatility falls.
Volatility Index Term Structure
The VIX term structure is the difference in prices between short-term and long-term VIX futures contracts. In other words, the VIX term structure depicts the relationship between VIX futures prices and maturity dates. This is an important concept to understand when trading the VIX.
There are three possible states for the VIX term structure:
- Upward Sloping (Contango): When longer-term VIX futures are more expensive than shorter-term VIX futures. In other words, when the VIX is at a level below the short-term VIX futures. Over time, all VIX futures contracts will converge towards the VIX (assuming the VIX doesn't rise substantially). Contango occurs more often as it takes place when implied market volatility is low. This is reasonable, given that since 1990, 61% of the VIX closes have been below 20.
- Downward Sloping (Backwardation): When longer-term VIX futures are cheaper than shorter-term VIX futures. In other words, when the VIX is at level greater than the short-term VIX futures. Over time, all VIX futures will appreciate in value as they converge towards the VIX (assuming the VIX doesn't fall substantially). Backwardation is not as common as contango, given that it typically only occurs when implied market volatility is high. With this in mind, if the market falls significantly and the VIX spikes, the VIX futures curve is most likely in backwardation at this time.
- Flat: When longer-term VIX futures are approximately the same price as shorter-term VIX futures.
To briefly elaborate on these three states, when the VIX futures curve remains in contango, bullish volatility strategies and products will likely not perform well (given the VIX does not increase substantially). On the other hand, when the VIX futures curve remains in backwardation, bearish volatility traders tend to lose money over time if the VIX does not decrease.
If you have a bearish trading strategy, VIX futures contracts will increase in price towards the VIX as their settlement date approaches. Moreover, if the VIX remains high, your volatility trades will not perform well, as most volatility products and strategies are tied to the performance of shorter-term VIX futures contracts. Because these VIX futures contracts will be increasing if the VIX remains high, bearish volatility products and strategies will likely not provide good results.
S&P 500 Expected Range
The VIX can also be used to calculate the expected range of the S&P 500 (SPX) for the 1-year period:
S&P 500 1-year expected range = S&P 500 price ± S&P 500 price * (VIX / 100)
Because these expected ranges are within one standard deviation, these ranges are only the 68% probability ranges. Therefore, if the VIX is at 20 and the SPX equals $1000, the 20% expected range (20 / 100) is just the 68% probability range. In other words, with the VIX at 20 and the SPX at $1000, there's a 68% chance that the S&P 500 will be between $800 ($1000 * 80%) and $1200 ($1000 * 120%). Given, this also means that there's a 32% chance the SPX will be outside this range as well.
The table below helps to further illustrate the calculation for the S&P 500 1-year expected range:
Exchange Traded Funds/Notes for the Volatility Index
While the VIX Index cannot be directly traded, trading VIX options and futures can provide exposure to movements in the VIX. Even so, the challenge when trading VIX futures is due to what’s called “contango,” where future contract prices are often higher than the expected spot price. However, when you invest in an ETF/ETN created to provide direct exposure to the VIX, the fund is investing in VIX futures contracts that will automatically roll-over every month after they expire.
Therefore, given the complexity and risks associated with trading options and futures, investors can opt into trading exchange traded funds/notes (ETFs/ETNs) instead. These products were specifically created to help investors gain exposure to the VIX. However, these VIX ETFs/ETNs use VIX futures indices as benchmarks, which causes them to fall short when tracking the VIX.
Popular funds designated to provide exposure (NOT directly track) the VIX are listed below:
- iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX): $1.03B AUM, 0.89% expense ratio.
- ProShares Ultra VIX Short-Term Futures ETF (UVXY): $1.01B AUM and 0.95% expense ratio.
- ProShares VIX Short-Term Futures ETF (VIXY): $383.33M AUM and 0.85% expense ratio.
- ProShares VIX Mid-Term Futures ETF (VIXM): $106.9M AUM and 0.85% expense ratio.
When selecting a VIX ETF/ETN, the "term" and expectations for the direction of future moves in implied volatility is particularly important. To begin, "short-term" refers to VIX expectations within one month, while "mid-term" refers to VIX expectations within five months. In practice, you should stick with trading short-term VIX funds as they generally capture a greater percentage of daily VIX moves.
In this article, I will focus on the VXX, as it's the largest VIX ETN (as of writing).
The VXX Explained
The VXX is a volatility product that attempts to track the VIX through the daily percentage returns of the short-term VIX futures. The VXX tracks the S&P 500 VIX Short-Term Futures Index, which tracks the two shortest-term VIX futures contracts with a weighted average time to maturity of 30 days.
The VXX closes at 4:00PM EST on each trading day, while the VIX futures closes at 4:15PM EST. So, after the VXX closes, there's an additional 15 minutes for those short-term VIX futures to change price. Therefore, if short-term VIX futures experience a price movement in those last 15 minutes after the VXX has closed, then there will be a discrepancy in the returns on the following trading day.
Based on daily adjusted closing price data between the VIX and the VXX from January 25, 2018 to August 31, 2021 (data pulled from Yahoo Finance), the two indices correlate 38.48%. This implies that the VXX captures 38.48% of the daily move in the VIX. For reference, InvestorPlace, in 2010, stated this percentage to be about 50% on a day-to-day basis. On the other hand, Russell Rhoards from CBOE stated that the VXX and VIX have been in sync between 77% and 89% of the time. Clearly, this exact figure varies. Regardless, neither the VXX, nor any product or investment, is a perfect representation of the VIX.
The live comparison chart between the two indices can be seen below:
Because the VXX tracks the performance of short-term VIX futures, the VXX will lose value as the futures get "pulled" lower towards the VIX. On the contrary, the VXX will gain value as the futures get "pulled" higher towards the VIX as well.
Additionally, when the VIX futures are in contango, VXX tends to perform poorly as the shorter-term VIX futures lose value as they're "pulled" lower towards the VIX. Moreover, when the VIX futures are in backwardation (VIX above VIX futures), the VXX can rise substantially as the shorter-term VIX futures appreciate as they're "pulled" higher towards the VIX.
Analyzing the Volatility Index as a Hedge
In the rest of this article, I will be analyzing the VIX as a hedge over six time frames. Correlation will be used to determine whether the VIX was a strong or weak hedge over these periods. Finally, I will back-test the data to perform a hypothetical scenario to better judge how well the VIX would've acted in a portfolio over these six periods, assuming it took up a 5% or 10% portion of a portfolio -- as compared to a portfolio invested in the SPX.
Keep in mind that I'll be analyzing the historical data of the VIX and the SPX. As you know, the VIX is not a tradable index. Therefore, the correlations and performances you will see (e.g., from buying the VXX) may be less than what the VIX is able to produce.
Prior to evaluating the VIX as a hedge, it's important to understand what correlation is and how we can use it to analyze the value of investing in the VIX as a hedge.
Correlation is the interdependence of variables that ranges from -1 to +1. A perfect positive +1 correlation means that the two assets move together. A perfect -1 correlation means that as one asset goes up, the other always goes down.
Below is a list of correlation ranges and its respective level of correlation:
- +/- 0.9 - 1.0: Very strong correlation
- +/- 0.7 - 0.9: Strong
- +/- 0.5 - 0.7: Moderate
- +/- 0.3 - 0.5: Low/Weak
- +/- 0 - 0.3: Negligible correlation
When it comes to the VIX and determining whether it's a good hedge for one's investment portfolio, we should expect to see measures close to zero or in the negative range. The more negative the correlation, the better of a hedge the asset (VIX) is. Another thing to examine is whether VIX prices appreciated more than the stock market during this downturn period.
For the following examples, keep in mind that correlation can vary depending on the time frame selected and that past performance is not an indicator of future results. Moreover, I will be comparing the performance of the SPX and VIX prices since the start of the selected period by percent change, which ignores any price movement prior to the given period.
The Dotcom Recession lasted 8 months, from March 2001 to November 2001 (highlighted area). The chart below shows the market high (roughly) from March 2000 to the low in October 2002, before the market began to recover again:
As the chart shows, SPX and the VIX generally acted in an inverse manner, which is more apparent in sharper market pullbacks. In this case, owning the VIX would've helped to offset your stock market investment losses, given the 144% gain for the VIX and 36% drop in value for the SPX (from March 2000 to October 2002).
The correlations between SPX and the VIX for these two periods are below:
- 03/01/2000 - 10/31/2002: -0.62
- 03/01/2001 - 11/01/2001: -0.85
From these two periods, SPX and the VIX have a moderate to strong negative correlation.
The Great Recession lasted from December 2007 to June 2009. The highlighted area from May 2008 to March 2009 represents a period of significant losses until the market began to recover:
As you can see, the VIX increased 342% in value at its highest point, when the market outlook was rather uncertain. Clearly, owning the VIX over this period would've been beneficial, given the 107% gain for the VIX and 37% drop in value for the SPX from December 2007 to October 2009. It goes without saying that selling one's VIX positions prior to the market recovery would've provided better returns.
The correlations between the SPX and the VIX for these two periods are below:
- 12/03/2007 - 06/29/2009: -0.77
- 05/01/2008 - 02/27/2009: -0.87
From these two periods, SPX and the VIX have a strong negative correlation.
The COVID-19 Recession officially began in late February 2020 and ended in April 2020. The highlighted area (in the chart below) from late February 2020 to June 2020 represents high market volatility, and is generally when there was a lot of uncertainty in the market. Ideally, this is when investors were buying the VIX if they had not already.
We can look at the most recent recession caused by COVID-19, and how the VIX performed over this same period:
This market downturn was rather short (2 months) and recovered quickly. Regardless, the large amount of uncertainty and fear COVID-19 brought led the VIX to spike 531% on March 16, 2020 (since Feb. 20, 2020). Overall, despite the market climbing back to 110% of its original starting value, the VIX still saw sporadic spikes in volatility and concluded at a 213% price increase on January 29, 2021. Clearly, it appears that owning the VIX during this period would've been a valuable hedge.
Again, the correlations between SPX and the VIX for these two periods are below:
- 02/20/2020 - 01/29/2021: -0.81
- 02/20/2020 - 05/29/2020: -0.89
From this data, SPX and the VIX appear to have the strongest negative correlations out of the other two recessions.
Hypothetical Scenario Analysis
From the scenarios above, we saw various market conditions and how the VIX reacted to significant market downturns. Overall, it's fair to say that the VIX would provide strong hedge benefits to a stock portfolio, at least according to these three market corrections.
Now, I will perform a hypothetical scenario analysis where I would've invested a total of $10,000 at the beginning of each of the six periods discussed before, but 5% ($500) or 10% ($1000) of my portfolio would be in the VIX, instead of just the SPX. To reiterate, I will compare this to exclusively owning the SPX:
As you can see, a 5% or 10% allocation to the VIX in an investment portfolio prior to these stock market crashes would've worked greatly in your favor as a hedge to offset losses, particularly in the COVID-19 recession. However, keep in mind that this hypothetical ignores compounding and assumes you only invest in the SPX, and not any other asset. Regardless, from these six market pullback examples, it appears that the VIX is a worthwhile hedge to invest in during times of economic trouble.
Volatility Index Trading Strategy
From the hypothetical scenario above and the information provided on the VIX in this article, it's clear that trading the VIX can be a valuable hedging strategy if executed properly. The strategy that I follow when trading the VIX is as follows, given that it's an asset worth trading over the short-term (e.g., through simply owning the VXX), as the VIX is not a long-term buy and hold asset.
To begin, you must assess whether it's worth having exposure to the VIX in the first place:
- Assess interest rates, inflation levels, and the current market environment.
- Evaluate the yield curve and see if it's inverted (and for how long).
- Determine whether the stock market is overvalued.
- Examine whether the VIX is below 15 (sometimes 20).
If the yield curve has experienced a prolonged inversion, if the market appears overvalued, and/or if interest rates or inflation is not at a desirable level based on the market environment, then I would begin allocating my portfolio to have 5-10% exposure to the VIX. Given, this would be particularly beneficial the lower I can purchase the VIX for (e.g., below 15), which should be possible in a bullish market environment. Naturally, this would provide some kind of protection if the VIX happened to fall even lower and/or if my market speculation was incorrect.
If the market crashes as you predicted and you have 5-10% of your portfolio exposed to the VIX, you should gradually sell the VIX position and buyback the cheaper equities. In this case, let's assume 10% of your portfolio is allocated towards a VIX product:
- When VIX breaks 30-40: Sell 50% of the VIX position. Buy the market dip.
- When VIX breaks 50-60: Sell the entire (other 50%) VIX position. Continue buying the market dip.
Your trading strategy can vary, but this is the general process to follow. Furthermore, when the VIX falls back to below 15-20, then you can begin accumulating more VIX positions, assuming that you've assessed the exposure is worthwhile. Ultimately, by implementing this short-term hedging strategy, you can develop a strategy to protect your portfolio while taking on considerably less downside risk.
VIX Trading Risks
It's important to reiterate the risks of investing/trading the VIX, despite its potential hedging benefits. At the very least, keep these four concepts in mind before trading the VIX:
- There's no product in existence that can track the VIX 100% accurately.
- The market must decline substantially after you gain exposure to the VIX, otherwise you're just owning a declining asset. Examining any of the VIX charts provided in this article should make this apparent.
- When you own the VXX (or a similar ETF/ETN), or if you buy options on the VIX, you're essentially layering more derivatives on top of contracts that already have derivatives. This can lead to an expensive and quite risky strategy.
- Although trading VIX futures can be considered the "safest" route when investing in the VIX, the VIX futures curve is typically upwards sloping (in "contango"). Therefore, if you're hedging an event in the future, you're already paying a premium, thereby setting a high bar for yourself when entering the trade.
The Bottom Line
In summary, the Volatility Index (VIX), otherwise known as the "fear index," was created by CBOE and tracks the 30-day implied volatility of the SPX, using options expiring between 23-37 days as inputs. The VIX is not directly tradable, but investors can trade options, futures, ETFs, and/or ETNs created to provide direct exposure to the VIX. Investors should also not see the VIX as a long-term asset to buy and hold, but rather one to develop a trading strategy for and execute to adequately hedge a stock portfolio.
Often times, the VIX increases in value during times of market uncertainty and fear, and decreases in value when the market is complacent or bullish. This fear in the stock market can therefore be used to our advantage to protect our portfolio on market downturns, particularly through owning 5-10% VIX positions in one's portfolio and following the trading strategy provided in this article. In practice, adhering to this short-term VIX trading strategy and acknowledging the risks associated with the VIX can provide significant market downside protection and enable long-term realized returns.