As part of my work at Mutiny Fund, I spend a lot of time trying to explain volatility as an asset class. The most common format for investors to learn about volatility is through the Volatility Index (VIX), a common measure of stock market volatility, and so I think it’s a good place to start both for better understanding the VIX itself as well as volatility more generally.
Sometimes referred to as the “fear index”, it can be a helpful proxy for understanding what’s going on in the market, but, as with any proxy, it can also be misunderstood. In this piece, we’ll look at what exactly the VIX is, why investors should care about it, how the VIX is calculated, what it can (and can’t) tell us about the overall volatility market, and some common ways to trade the VIX.
What is the VIX?
The VIX was conceived after the Black Monday crash in 1987. It uses option prices to gauge expectations for the speed and severity of market moves. If options are expensive, it suggests that market participants are worried and willing to pay more for “insurance”. If they are cheap, it suggests participants are unconcerned about a rapid sell-off that would spike volatility.
The push to develop was driven, in part, by Mark Cuban. In the summer of 2002 newly minted billionaire Cuban called Goldman Sachs looking for a way to protect his fortune from a crash. Because the VIX typically rises when stocks fall, he wanted to use it as insurance.
Devesh Shah, the Goldman trader who fielded the call, offered him an arcane derivative called a “variance swap”, and Cuban wasn’t interested.
However, it pushed Shah to develop the calculation we now use for the VIX. Shah handed the invention to the Chicago Board of Exchange (CBOE). The exchange launched VIX futures in 2004, and VIX options two years later. The firm billed VIX trading as a new risk-management tool and trading grew slowly.
When the financial crisis hit in 2007/2008, the only thing rising in the US was the VIX futures contracts that the CBOE had launched just a few years earlier. Since that time, VIX trading has developed and the market has grown substantially as the Global Financial Crisis in 2008 showed many investors the benefit of the VIX and volatility as an asset class to diversify their portfolios.
I think the best way to think about the VIX is as a real-time reading of prices for insurance on the US stock market, as represented by options on the S&P 500. If it were car insurance, imagine it would be like insurance re-priced in real-time. Premiums go up when you are in situations that the insurance provider deems risky: You’re driving too fast, it’s raining, or you are fiddling with the radio. It would go down when you’re doing things that seem safe such as sitting parked in your garage.
An option is a financial instrument that allows investors to buy and sell the right, but not the obligation (i.e. the “option”) to buy or sell an underlying asset at a specified time at a specified price.
- Call options allow the holder to buy the asset at a specified time at a specified price. A call option generally benefits when the price of the underlying asset increases over time so it is a bet on the market going up.
- Put options allow the holder to sell the asset at a specified time at a specified price. A put option generally benefits if the price of the underlying asset will decrease so it is a bet on the market going down.
For example, if there is a stock currently trading at $100, you could buy a put option for the right to sell the asset at a specified time (say the end of next month) at a specified strike price (say $90).
Let’s say this option costs $1. So, you pay $1 up front for the right to sell the stock for $90 at the end of the coming month. If the price of the stock falls to $85 in that time period, you can buy the stock for $85 and use your option contract to sell it for $90, pocketing a $4 profit once you deduct the $1 you paid for the option.
If the stock ends the month at any price higher than $90, then the option expires worthless and you lose the $1 you paid for the option.
A put option is conceptually similar to an insurance policy. The price of the option (in this case, $1) is equivalent to an insurance premium that you pay whether you use the insurance or not.
The difference between the strike price and the current price is like the deductible portion of the insurance: the amount you owe out of pocket before the insurance kicks.
In this case, the $10 difference between the current stock price ($100) and the strike price ($90) is like the deductible: you can lose $10 “out of pocket” before the insurance kicks in.
The VIX is a measure that incorporates many different option prices as a way of providing a single number that acts as a high level gauge of market stress.
Why the VIX Matters
The VIX index matters, in part, because it is a useful single number for gauging market stress. While it’s a simplified gauge (as we’ll look at below), it is a pretty good single indicator to look at to see overall market stress and a lot easier than looking at tons of different options.
The VIX also matters because trading strategies using VIX derived instruments can be additive to investor’s portfolios because they can be implemented in a way that creates an uncorrelated or even anti-correlated return stream to equities.
Though it’s common for investors to hear phrases like “diversification is the only free lunch in investing”, many fail to realize the full power of adding uncorrelated assets to a portfolio. Let’s say you have two assets, both with a positive expected return but uncorrelated with one another. If you rebalance between them every day, then the combined portfolio performs much better than either asset alone.
In a study by Resolve Asset Management, they concluded that “the most diversified risk parity portfolios produced a rebalancing premium of more than 3 percent per year”. Over the long term, this adds up to a lot!
A $10,000 investment compounded at 7% annually would be worth $76,123 after 30 years. If you compounded at 10% instead of 7%, it would be worth more than double that: $174,495. Even small differences in compound interest add up over the long term. $10,000 compounded at 8% annually would be worth $100,627 after 30 years, 32.2% more than compounding at 7%.
That’s why effective diversification can make such a big impact on long-term wealth.
While many investors diversify across different buckets of bonds, stocks, and real estate, these have historically all been correlated with market cycles.
An analysis by the CBOE Options institute showed that the VIX Index had a correlation of -0.68 to the S&P 500 Index and a -0.50 correlation to the MSCI EAFE Index making it a good potential candidate for adding diversification to a portfolio with equity exposure.
In periods of high stress like October 2008 or March 2020, volatility (of which VIX is one measure) can be the one asset class that performs well. If implemented properly, that means volatility trading strategies utilizing the VIX can help to improve the long-term, risk-adjusted returns of a well-diversified portfolio. (As we will see below, there are many ways for VIX trading strategies to not work and investors should approach them with caution.)
How is the VIX Calculated
The options prices that feed into the VIX calculations are designed to be looking 30 days out, so it’s an estimate of relatively short-term volatility.
The historical average of the VIX is around 20 though it tends to be bimodal: clustering around 12-15 in calm years for the market and then clustering around 25-30 in volatile years.
As noted above, the VIX tends to spike during large stock market declines. On October 24, 2008, during the heart of the financial crisis the VIX reached 89.53. The VIX and volatility more generally tend to be inversely correlated with the equity market. When the equity market is rising, it tends to do so fairly steadily with low volatility (e.g. 1992-1997, 2003-2006). When it is falling, it tends to do so more violently (e.g. October 2008, March 2020).
So the typical relationship is stocks up/VIX down or stocks down/VIX up. There are, of course, exceptions such as melt-up scenarios like ‘98-99 (stocks up, VIX up) and September/October 2020 (stocks down/VIX down).
Since these correlations are typically negative, properly implemented trading strategies using the VIX can be an effective form of diversification for investors with equity exposure in their portfolios over a full market cycle.
The VIX is a (useful) simplification of the volatility surface
It is common to see the VIX referenced in financial media as a shorthand for what is happening with market volatility, but the relationship isn’t quite so straight forward.
As noted above, the VIX is calculated using listed option prices on the S&P 500 30 days out. However, the CBOE also has indices on option prices for 9 days, 93 days, 180 days, and 1 year out. So it’s possible that the VIX is high indicating option prices 30 days out are elevated, but they may be lower (or higher) 93 days out, or 180 days out.
There’s also the need to reflect what is happening across many different option strike prices. The strike price of an option is a fixed price at which the owner of the option can buy, or sell, the underlying security or commodity.
For instance, if a given stock is trading at $100 today and you wanted to buy a put option for 30 days in the future because you believed the price was going to decline, then you could buy it at many different prices: $99, $98, $95, $90 or $85. Each of these contracts has a different implied volatility that is reflected in its price.
The implied volatility is a measure of the perceived riskiness of a certain option. It is kind of like the car insurance that tends to go up in perceived periods of high danger and down when things are smooth sailing. Returning to the example I gave above of a put option being $1 for a $90 strike price 30 days out, that could go up to $2 if market participants are more worried or down to $0.50 if they are less worried.
If the price of the option goes up then the implied volatility tends to go up: by paying more for the option, market participants are implying they expect higher volatility.
Each different option has its own implied volatility based on what market participants are willing to transact for. So the implied volatility of the 30 days out $90 option on a given stock may be slightly different than the $98 or $95 strike options on the same date.
The VIX accounts for this by sampling between 175 and 200 option prices (you can see the listing here if you’re interested). This makes it more useful than the volatility of a single option and is why it is a pretty good proxy.
But, every now and then the timing (and/or the pricing) matters and make it not a great proxy. For example, what happens when there is a potentially world-changing event – like a highly contested US election – smack dab in the middle of that 30-day window?
In that case, option prices around that date may be very elevated as investors are expecting volatility leading up the event, but much lower volatility afterwards.
In that case, 30 days before the election, the VIX may be high even though a measure of volatility 60 days out would be much lower making it not the best reflection of overall market volatility expectations.
Volatility traders analyze all of this data in what they call the “volatility surface”, which looks something like the 3D plot below that includes three variables:
- The implied probability from option contracts
- Across different strikes (moneyness)
- And maturities (time to maturity).
For any given security like the S&P or a stock, there are options with a time to maturity of 1 day, 1 week, 1 month and 1 year. For each of those time periods, there are also many different strike prices. An investor could buy a call option for $101 in one week or $105 in one month. Each of these options has an implied volatility that reflects how much investors are willing to pay up.
The volatility surface captures all three of these elements in a 3D plot like we saw above.
The VIX, on the other hand, is representative of just one 2D “slice” at one point in time (30 days out) of one index: the S&P 500. Most of the time the volatility surface is fairly “flat” so that a 2D slice of a popular index like the S&P 500 is a pretty good approximation for overall market volatility.
However, in some circumstances (like a contested US presidential election and many others), the volatility surface can get a lot wonkier. In the volatility surface below, we can see peaks and valleys, which represent nuanced market views on when and where volatility may emerge.
The VIX doesn’t usually reflect all the subtleties inherent in that case. That’s why it’s possible to see VIX spikes where volatility trading strategies trading other parts of the volatility surface perform poorly (as well as VIX declines where they perform well).
Given all the possible trades that volatility traders can place, it is possible (and not uncommon) that few actually capture the full thrust of any given VIX spike. In the chart above, you can see that the red portion is spiking up, but you can also see other portions of the surface going down.
In that kind of setup, the VIX doesn’t do the best job at reflecting what is happening across this entire surface, much less the volatility surfaces for other assets than just the S&P.
At any point in time, you could calculate a volatility surface for the S&P, Nasdaq, Hang Seng or an individual security such as Apple ($AAPL) or Google ($GOOG).
All that to say, collapsing the world of volatility into one representative number, the VIX, is a helpful compression. However, it’s just that, a compression or proxy. By just looking at the VIX, you are missing a lot of the detail that actually happens inside the world of volatility.
For instance, if some company has a large regulatory decision looming in the future, then the volatility surface for its stock would likely be very different from the VIX since a single company would only minimally impact the entire S&P 500 Index. It’s possible that S&P at-the-money options can experience no spike in volatility at the same time that out-of-the-money options do see a volatility spike.
If it’s all so complicated, why not just trade the portion of the surface which aligns with the VIX?
Traders analyze these volatility surfaces to pinpoint opportunity, sometimes finding trades where they believe a portion of the surface to be underpriced or overpriced. Traders search out those types of mispricings which sometimes are seen in the VIX but often are not. Spikes in volatility can emerge on another part of the volatility surface and many traders seek out the broader opportunity set.
If you think there’s a mispricing in $AAPL’s volatility surface, then VIX-derived instruments wouldn’t be a very good way to take advantage of that.
If everyone was just trading the VIX, then it would leave a lot of opportunity elsewhere for traders to capitalize on and so many volatility traders focus on other parts of the volatility landscape than just the VIX.
The VIX is not an Investable Index
It’s also important to know that the VIX is not an investable index. When you see the price of a stock or bond on CNBC or Yahoo finance, it generally means you can go buy a that security for that price.
When you see the VIX up +40%, that doesn’t necessarily translate into gains for long volatility strategies (or losses for short volatility strategies) There are a couple of reasons for this.
First, that VIX number is measuring floating strike volatility when the instrument you can actually buy is fixed strike volatility.
As a toy example: say the VIX is at 10, and you buy a put -5% out of the money on the S&P. Because whoever is selling you that put is going to demand some compensation for this risk they are taking, you will typically have to pay up. Let’s say the implied volatility for your put option is priced at 15.
So, as the market moves down towards your strike the VIX goes from 10-14, “+40% increase.” However, your puts are still down 1 volatility point: your put was a bet implied volatility would go above 15, but it only went to 14. You are actually down -6.6%.
This is not an uncommon dynamic. Underneath the surface, fixed strike volatility can sometimes remine surprisingly quite despite the spot VIX number moving around a good deal.
Second, to add some more to the confusion, VIX itself is a percentage and it doesn’t mathematically make sense to quote a percentage change in percent. Let’s say you had a strategy that was up +10% on the year and then it increased to +20% on the year. You wouldn’t say it “increased 100%” even though it doubled from +10% to +20%. You would say it increased 10%.
In the same way, the spot VIX number going from 10 to 20 isn’t like the price of a stock going from $10 to $20. It’s a percentage, not an absolute number.
How to Invest in the VIX
So how can you invest in the VIX if there is no spot VIX that you can buy? The VIX is derived using tradable options so you could go buy those options. However, actually trading those options to track VIX is non-trivial (read: effectively impossible – you’d be trading hundreds of different options all the time).
To overcome that impossibility, the Chicago Board of Exchange (CBOE) offers VIX futures, which has become one of the most successful futures contracts of all time.
VIX futures, like other futures contracts, have an expiry date. The 2020 October VIX futures, for example, expired on October 21st, 2020. Anyone holding long contracts as of that date would have the exit price (the sale) of their trade be the settlement price on that date. Anyone holding short contracts as of that date would have the exit price (the purchase) be the settlement price on that date.
If you wanted to keep exposure to the VIX via futures, you would need to sell the October futures contract before the 21st and buy the November contract. That November contract, however, is essentially a bet on where the VIX index will be on the November contract expiration (Nov. 18, 2020 in this example).
So, purchasing a November contract is a bet about where the market’s expectation for forward 30-day volatility will be at expiration on November 18. So, it’s not so simple as just knowing if volatility is going up or down as there is no way to simply buy spot VIX, the number most often quoted in financial media.
If you plot all the VIX futures contracts out over their maturities, you get the VIX futures curve.
This is what the VIX future curves looks like in most “normal” situations. The VIX futures curve has an upward slope in more normal, low volatility environments because most of the time markets are calm, but there is always the possibility that something bad could happen in the future.
The further out into the future you go, the more time there is for something bad to happen and so people are willing to pay more for a contract that covers more time. This is typically (but not always) reflected in the VIX futures curve.
You can see in the image above that the front-month VIX futures contract is trading at 10.825 while the second month is at 12.475 and the back month is at 16.5. This shape of an upward sloping curve is referred to in the futures industry as “contango”.
The VIX Futures curve can also have the opposite shape where the front month contract is elevated and then it slopes down over time. This tends to happen after some major crisis event.
This image is from October 16, 2008 during the heart of the financial crisis.
When the curve is sloping down like this, it’s typically suggesting something like “things are crazy right now, but they likely won’t stay crazy forever so I’ll pay more now for protections, but I am willing to pay less later when I expect things will calm down.” This shape is referred to as “backwardation”.
Though contango and backwardation are the two most common shapes to the VIX futures curve, it can be in pretty much any configuration depending on what is going on in the market.
Take this example of what the curve looked like going into the 2020 election. In this instance, there was a known big event so that the front half of the curve was in contango leading up to the election while the back half was in backwardation.
This makes a certain kind of sense: something bad seemed more likely to happen around the election but less likely before or after so the futures contract nearest the election had the most elevated volatility.
Since the spot VIX is not a tradable instrument, volatility traders always have to make a choice about which contract to buy. For instance, the 2020 election was a known risk so buying the contract associated with the election meant buying a contract already priced for high volatility.
It is not enough for volatility to spike for a long VIX trade to make money, it has to spike even more than what the market has already priced in. In the case of the 2020 election, it ended up being mostly a non-event as it related to market volatility.
Because the VIX is not an investable index and the futures have a curve associated with them, it’s possible for spot VIX to diverge somewhat from the investable instruments like futures.
Consider October 2020 as an example. While the spot VIX number everyone looks at did rise sharply month-over-month, investable instruments tracking volatility were up much less. Front month VIX futures, for example, were only up 7.5% despite the VIX index climbing some 45%.
Because the VIX is a measure of volatility expectations for a certain time frame, and the investable products have different time frames and structures as we looked at above, this is something you would expect to see from time to time.
The bottom line of the VIX’s various idiosyncrasies is that the VIX number is a useful, but imperfect measure of how trading strategies utilizing the VIX or options perform.
Whether it reflects the performance of a volatility trading strategy depends on where they are trading on the volatility surface, whether the entire surface is moving along with the VIX reading, and the shape of the VIX term structure.
How to trade the VIX
There are many ways to trade the VIX, the most common ones used by professionals are relative value strategies.
A relative value strategy is an actively managed strategy that seeks to exploit temporary differences in the prices of related securities.
A common example of a relative value strategy would be that if you expect Coke to outperform Pepsi, you would be long $100 worth of Coke stock and short $100 worth of Pepsi stock.
Relative value strategies seek to reduce the impact of broader phenomena on a trading strategy. In this example, let’s say you are right that Coke is going to outperform Pepsi and so you just go long Coke. If the entire market crashes by 30%, but Coke only goes down 25% and Pepsi goes down 35% then you still lost 25% even though you were right about Coke doing better than Pepsi.
By using a relative value approach, you would have made money because the relative value of the assets changed in the way you expected. You made more money on your short Pepsi position than you lost on your long Coke position.
Relative value strategies are common in VIX trading because VIX futures can be extremely volatile (surprise, surprise!). Being just short the front month VIX futures contract, betting volatility will go down, when a big volatility spike comes like March of 2020 can result in 50% or greater losses in just a few days. Similarly, being just long the front month VIX futures contract in a period of declining volatility such as following the March 2020 Coronavirus sell-off can lead to losses of over 50% in the space of a few months.
Relative value strategies allow volatility traders to have exposure to the VIX while mitigating their risk of either “bleeding” in calm markets or blowing up in volatile markets.
Two of the most common relative value strategies are
- VIX Calendar Spreads
- The VIX/S&P Pairs Trade
VIX Calendar Spreads
VIX calendar spreads involve selling one (or more) contracts on the VIX curve while buying another (or more).
A simple example would be selling the front-month futures contract and buying the second-month futures contract. In this case, you are betting on volatility falling faster in the front month than in the second month. Even if both fall or both rise, you can still profit if the relative value changes in the way you predicted.
If you are wrong and volatility does increase in the short term, then it is likely to increase some in both contracts and so you are, to some extent, hedged. Your losses on the front month should be somewhat offset by your gains in the second-month.
Knowing when to put on this trade and which contracts to use is extremely difficult to do profitably. Experienced VIX traders typically use proprietary trading algorithms based on historical research and years of their own experience to try to identify what they believe are relatively cheap and expensive parts of the curve.
By selling the expensive part of the curve and buying the cheap part of the curve, they are betting on the relative value moving into line with what their models predict. They are also hedging the exposure since a large spike somewhere in the curve is likely to show up to some extent elsewhere.
For instance, if the front month futures contract is at 12 and the second month is at 15, then a large spike in volatility (say from 12 to 20 in the front month contract) is typically accompanied by a spike in the second month (say from 15 to 19). If a trader is positioned long in the front month and short in the second month, they will show a profit because they made more in the front month (+$8,000) than they lost in the second month (-$4,000).
However, they are also hedged. If the reverse happens and the front month futures declines from (say 12 to 10) then the second month is also likely to decline (say from 15 to 14). Though the position shows an overall loss of (a -$2,000 loss in the front month and a +$1,000 gain in the second month leads to a -$1,000 net loss in this example), it is still hedged from a larger loss that would have resulted in just being short the front month.
Typically, being short the front month and long the second month would be a bet on volatility declining in the near term.
Being long the front month and short the second month would be a bet on volatility rising in the near term.
This is a pretty simple and naive example. Given the number of futures contracts available to trade, there are many ways to implement this trade (e.g. one could go long front month, short second month, long third month betting that the second month declined as the front and third months rose.)
VIX S&P Pairs Trade
The VIX/S&P pairs trade typically involves either going long both the S&P and VIX at the same time OR short both the S&P and VIX at the same time.
Recall that the VIX is calculated based on S&P option prices and options tend to increase in value around large sell offs. That means that the VIX and S&P are typically negatively correlated to one another. If the VIX rises then the S&P will typically fall and vice versa.
By being long the VIX and long the S&P, a trader is typically betting on volatility expanding but also being somewhat hedged as declining volatility is usually accompanied by rising equity prices.
Being short the VIX and short the S&P is a bet on volatility declining but also being somewhat hedged as a market sell off would cause a spike in the VIX (leading to losses) but a decline in the S&P (leading to some offsetting gains).
Similar to calendar spreads, traders using this strategy effectively are using proprietary algorithms to determine when it is better to be long VIX and long S&P or short VIX and short S&P and in what ratio to implement the trade.
For instance, if a trader thought volatility was likely to increase they might go long the VIX but also long the S&P as a hedge in case they are wrong. This is based on believing that if the VIX falls, then the S&P will likely rise around the same amount volatility decreases helping to prevent or minimize losses, but that if the VIX does increase – it’s likely to do so at a much higher rate so that they will make more money on the VIX side of the trade then they lose on the S&P side of the trade.
Of course, it’s also possible that they lose on both sides of trades so good risk management matters a lot.
Both these strategies can be considered called relative value because they are going short one thing and long another related thing making them bets on the change in the value of one of those relative to another one.
Because these are relative value trades, they can do well in either rising or falling volatility markets. Most other long volatility strategies tend to only perform well in periods of rising volatility (Of course, the knife cuts both ways and this strategy can also perform badly in both instances). This can make it an effective diversifier that is uncorrelated to equity markets and other long volatility strategies.
By being able to profit in periods of declining volatility as well as periods of rising volatility, I believe relative value strategies using the VIX are a valuable component of a broader long volatility strategy.
Both the VIX Calendar Spreads and the VIX/S&P Pairs Trade can be very challenging to implement effectively and require constant monitoring and updating of models as the market environments shift. Don’t try to trade the VIX at home without doing a LOT of homework (and even then, we would urge caution – you’re playing with nitroglycerin!).
Because of their historial negative correlations to equities, I believe investors seeking to diversify their portfolios and improve their long-term returns should consider volatility trading strategies such as those that use VIX futures or other VIX-derived instruments as they can be a powerful component to a portfolio.
However, don’t forget that volatility trading is hard, multi-dimensional stuff not easily summarized into a tagline that volatility trading strategy x does y when VIX does z. It’s nuanced and reliant on the factors of time, distance, and volatility.
At Mutiny Fund, we believe that an ensemble of active managers is the best way to get exposure to long volatility including Dynamic VIX strategies such as the ones explained here. Given the many different ways and places in which volatility can emerge on the volatility surface, we believe that it benefits from active management and using an ensemble of active managers seeks to diversify across different strategies in a way that seeks to improve long-term, risk-adjusted returns.