Traders have used the CBOE Volatility Index, or “VIX,” to hedge against market swings, and with exchange traded products, anyone can also gain access to the strategy. However, there are some quirks investors considering volatility products should understand first.
Exchange traded products’, including ETFs and exchange traded notes, moves typically reflect the so called negative roll yield – funds sell short-dated futures that are about to mature and purchase longer-dated contracts, which can become costly in a contangoed market where later dated contracts cost more than near-term contracts, writes Brendan Conway for Barron’s.
Consequently, investors should be aware that the funds do not perfectly reflect the spot price of the VIX.
Additionally, investors should understand that the volatility-related ETF can experience high volatility of its own.
“People perceive the VIX as being an appropriate hedge, but as the price action shows over these last couple of days, its moves can be pretty quick and ugly,” Eric Augustyn, head of options strategy for Wells Fargo Private Bank, said in the article. “It moves too quickly.”
“It can be devastating if you judge it wrong,” Jack Ablin, chief investment officer for BMO Private Bank, added in the article.
Nevertheless, VIX funds have helped investors ride out short-term spikes in volatility as equities plunge on any geopolitical flare-ups or poor economic data.
“If you think volatility is cheap, you may buy it as portfolio insurance, a way in which to guard against potential losses,” Chris Blum, global head of equities for JPMorgan Private Bank, said in the article. “It’s like many types of insurance policies, like life insurance or otherwise, you hope you don’t have to collect on it.”
The iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX) plunged 9.8% Thursday on reports that Congress had a working proposal to the debt ceiling drama. VXX is down 53.6% year-to-date, revealing the growing market complacency as the equities market rallied to all-time highs this year.
For more information on the CBOE Volatility Index, visit our VIX category.