By Peter Mastrantuono
The recent market turmoil may have introduced a new term for many investors, “the VIX”. It’s infrequently mentioned during calmer markets, but tends to get more discussion when markets are stressed. Aside from the basic awareness that the VIX is a measure of volatility, many investors may not fully understand the VIX and why it matters to them.
The CBOE Volatility Index, as defined by its creator, the Chicago Board Options Exchange, is a calculation designed to produce a measure of constant, 30-day expected U.S. stock market volatility, derived from real-time, mid-quote prices of the S&P 500 Index call and put options.
There are two key characteristics that make the VIX Index particularly useful to the investment community.
The price movements between the VIX and the S&P 500 Index are negatively correlated, which simply means that when the S&P 500 rises, the VIX will decline, and vice versa. This negative correlation has historically widened during exceptionally volatile periods, such as 2008.
The second important characteristic is what traders call the convexity of price moves. The percentages changes in the S&P 500 Index and the VIX are rarely a one-to-one relationship during volatile periods. Indeed, when the S&P 500 moves sharply lower, the increase in the VIX is disproportionately higher. For example, according to the CBOE, in August of 2015 the S&P 500 fell 6%, while the VIX Index rose 235% and the VIX September futures rose 72%.
The Uses of VIX Options and Futures
Traders and investors may use VIX futures and options in a number of different ways.
Perhaps the most valuable use of VIX futures or options is that they allow investors and portfolio managers to protect stock portfolios during times of broad market decline. A long exposure to the VIX will rise in value during falling markets, helping to offset some of the losses experienced in a stock portfolio.
Other uses of VIX futures and options are more trading oriented. For instance, they may be used to harvest risk yield premium by extracting the difference between the higher expected volatility built into the futures or options and the typically lower realized volatility of the S&P 500 Index.
Another trading strategy is to use the VIX futures or options to express a view on future volatility. If a trader believes that volatility will rise, he or she can take a long position in the VIX and profit from that position if volatility increases during the term of the contract.
Though many individual investors may not feel confident about employing VIX futures or options, there are a number of exchange-traded products that are good alternatives.
One of the challenges with using the VIX to protect portfolios is that they can become very expensive just when they’re most needed. That’s why it’s important to work with a seasoned financial advisor to craft a risk management strategy that fits your investment objective and tolerance for risk.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.