How can I make money trading the VIX?
That's one of the most popular questions we get from aspiring traders.
And they usually don't like the answer — because you can't trade the VIX.
The VIX — better known as the Chicago Board Options Exchange Volatility Index — is not a security, and thus the number you see on your screen is not a price.
It's actually a trading indicator.
The VIX uses prices of various S&P 500 options with expirations between 23 and 37 days to measure traders' expectations of volatility.
The VIX helps us measure sentiment by telling us how much traders are willing to pay for these options.
Typically, the VIX rises when traders are worried about downside risk.
Because when traders are worried about downside risk, they'll pay higher prices for downside protection through options.
Let's take a look at a 10-year monthly chart of the S&P 500 (bar chart) against the VIX (purple line):
The chart shows that the VIX had major spikes during the:
A) Financial Crisis
B) Flash Crash
C) Euro Sovereign Debt Crisis
D) August 2015 Minicrash
This illustrates how the VIX rises when traders are scared and markets are coming under pressure.
Again, because traders were willing to pay up big for downside protection through S&P 500 options.
The same dynamic plays out on shorter time frames.
As you can see in this 20-day hourly chart, when the S&P 500 (bars) rises, the VIX (purple line) falls:
And vice versa.
What You Can Trade
We told you before that you can't trade the VIX directly, since it is an indicator.
However, there are many derivatives of the VIX that can be traded.
But before we proceed further, you must understand that virtually all VIX-related instruments can be tricky to deal with.
And we urge you to read the prospectus and understand the pricing mechanics of any VIX-related instrument you trade.
VIX Options and Futures
The CBOE has created VIX futures and options.
VIX futures trade nearly 24 hours, 5 days a week.
And VIX options can be traded just as easily as a standard equity option.
However, keep in mind that VIX options typically expire on Wednesday, and VIX options contracts are based on the price of VIX futures, not the VIX itself.
There are many VIX-derived exchange traded products, the most popular of which is the iPath S&P 500 VIX ST Futures ETN (VXX).
The VXX aims to deliver the return of the S&P 500 VIX Short-Term Futures Index.
Many traders also follow the Credit VelocityShares Daily 2x VIX ST ETN (TVIX), which aims to deliver twice the daily return of the S&P 500 VIX Short-Term Futures Index.
VIX ETN's can be bought and sold like stocks.
However, they only appropriate for short-term trading since they don't track the VIX — they track VIX futures, which tend to naturally fall over time.
Here's a direct excerpt from the VXX prospectus:
The index underlying your ETNs is based upon holding a rolling long position in futures on the VIX Index. These futures will not necessarily track the performance of the VIX Index.
And for technical reasons related to the VIX futures term structure, they tend to decline over time:
On the flip side, shorting these instruments over the long run is not easy because of margin requirements and other issues.
Plain Old SPY Options
The easiest way to trade changes in the VIX may be to just trade SPY options.
They're very liquid and easy to trade with none of the complex mechanics involved with VIX futures, options, and ETN's.
For example, if you think the VIX is set to increase sharply, rather than messing with VIX products, you could simply buy SPY put options.
Because a higher VIX means higher put options prices.
Remember, the VIX is a measure of implied volatility on S&P 500 options. And all things being equal, when implied volatility goes up, options prices go up.
And on the flip side, to speculate on a falling VIX, one could simply buy SPY call options, since a falling VIX is typically associated with rising stock prices.
Sure, the VIX products are sexier and more exciting, but for newcomers to trading, simpler is often better.