Political risk and uncertainty surrounding presidential election have dragged on the equities market.
Investors, though, have hedged the risk through CBOE Volatility Index, or VIX, related exchange traded funds.
On the recent webcast, Trading VIX to Hedge Market Risks: What You Need to Know, Vinit Srivastava, Managing Director of Strategy and Volatility Indices at S&P Dow Jones Indices, pointed out that the VIX, or so-called investor fear gauge, typically touches its highest level during periods of market turbulence.
The VIX has historically shown a negative correlation to the S&P 500, which provides a suitable diversify during broad market selling. From January 1990 through August 2016, the VIX has exhibited a -0.71 correlation to the S&P 500 – a negative 1 reading implies perfectly noncorrelated assets whereas a positive 1 reading reflects perfect correlation.
“Implied equity volatility has historically had a strongly negative correlation to equity market returns and is considered a useful tool to hedge against the potential downside of the broad equity market,” Srivastava said.
Investors can gain exposure to VIX movements through the futures market and index-backed strategies that track VIX futures. However, the S&P 500 VIX Futures Index Series does not perfectly track the VIX spot price. Futures are less sensitive than the VIX spot to market movements, and the sensitivity declines with longer-dated VIX contracts.
“The implied forward volatility that these prices represent may not always track the VIX,” Greg King, Founder and CEO of REX Shares, said.
Moreover, since investors will be dabbling in the options market, futures traders will be exposed to the VIX term structure, or roll yield as determined by their term structure, which may result in contango or backwardation. Specifically, the VIX indices, along with related futures-backed VIX exchange traded products, are negatively affected by contango when rolling futures contracts.[related_stories]
Before the VIX contracts mature, the VIX indices and VIX ETPs will execute a forward roll or sell expiring contracts and buy a later-dated contract. However, when the futures market is in a state of contango, later-dated contracts cost more than near-term contracts, so the indices and ETPs essentially sell low and buy high on each roll.