How to Trade the VIX

How to Trade the VIX

The Chicago Board Options Exchange Volatility Index, commonly called the VIX, is a market index linked to expected stock market volatility over the next 30 days. When the VIX rises, it's expected that volatility will rise and stock market prices will fluctuate more quickly and sharply. Trading the VIX refers to making investments based on where the VIX itself is headed, which you can do by buying and selling futures contracts linked to the VIX or exchange-traded VIX products through your broker.

Understanding the VIX

The VIX is a measurement of the U.S. stock market's expected volatility over the next 30 days. It's administered by the company CBOE Global Markets based on the pricing of various call and put options related to the S&P 500 index.

Call options allow someone to buy a stock or another asset at a certain price, called the strike price, at a certain time. Put options allow you to sell the stock or asset at the strike price at a certain time. Call options, which take their name from calling for delivery of the asset, go up in value when it's more likely or expected that the asset price will exceed the strike price, since they'll let you buy the stock at a bargain price. Conversely, put options go up in value when it's more likely that the asset price will be less than the strike price, since whoever holds the options will be able to sell the asset for more than it's otherwise worth.

The option prices effectively can be used to capture investor sentiment about future fluctuations in the S&P 500. The measurement is sometimes popularly known as Wall Street's Fear Gauge, since it rises when people expect a bumpy change in stock prices that can make investing difficult rather than a smooth rise, decline or plateauing of prices.

The Evolution of the VIX

The VIX was first developed in the early 1990s based on the S&P 100 index. It's not technically correct to say that the VIX ever had an initial public offering, since it's not a stock that went through an IPO process, but the index did make its formal debut in 1993.

Since then, it's evolved in a few technical ways to better approximate future market volatility, and it's today based on the S&P 500 index. That index tracks the performance of 500 major U.S. companies on the stock market and is itself often watched as an indicator of overall market performance and is the basis for many index funds which allow investors to attempt to profit from overall rises in stock market prices.

CBOE has also introduced a number of other volatility indexes, including a Short-Term Volatility Index called the VXST that is based on a nine-day look at the S&P 500's volatility. Another index, the S&P 500 3-Month Volatility Index, or VXV, takes a longer outlook, and the S&P 500 6-Month Volatility Index, or VXMT, looks at a longer window still.

Other CBOE volatility indexes look at the performance of stocks on indexes besides the S&P 500. For example, volatility indexes are published by CBOE based on the tech-intensive Nasdaq-100 index, the famed Dow Jones Industrial Average and the Russell 2000 index, which focuses on 2,000 relatively small capitalization, or total market value, companies.

Historically, during typical market conditions, the VIX has hovered around 20, although it has been known to spike to near or above 100 during various historic market events like the 2008 financial crisis. When the VIX trades below 20, it's normally seen as a sign of atypically low market volatility.

Trading the VIX

The term trading the VIX refers to making financial transactions where you will make or lose money based on the direction of the VIX. That is, you are essentially making a prediction about market volatility increasing or decreasing and setting yourself up to gain or lose money if that prediction comes true.

There are several ways to make trades based on your expectations for the VIX.

Trading in VIX Options

One way to trade the VIX is to trade in VIX options. These are technically a bit different from stock options but work similarly in that call options will see you make money if the strike price is below the VIX level on the day the option expires and put options will see you make money if the strike price is above the VIX level on that day.

You can buy VIX options through the CBOE and many brokers, although broker requirements for options trading vary. Research online to find a broker that offers options trading and see what requirements you must meet to enable such transactions on your account. Under Securities and Exchange Commission rules, you generally need to be approved for trading options after filing an application with your brokerage and you may need to be approved for a certain level of risk, so make sure your application will allow you to trade VIX options or any other type of options that you want to deal in.

Take note of any special rules about how much money you must maintain in your account or any other requirements to keep your options trading in good standing. Remember that most options profits will be taxed at your ordinary income tax rate, which is generally higher than the long-term capital gains tax rate that you will pay on investments that you hold on to for a year or more. Take expected taxes into account when you're deciding between different ways to invest your money.

Remember that as with all investments, it is possible to lose money while trading VIX options, so make sure you understand the risks involved and don't invest more money than you can stand to lose. Consider how your entire portfolio is exposed to risk and how VIX options play into this.

VIX Exchange-Traded Products

Another way to trade the VIX is to buy exchange-traded products related to the index. These can be bought and sold similarly to stocks or exchange-traded funds through many brokerages. Look to find a brokerage that will let you buy and sell such products at a commission rate, if any, that makes sense to you.

You can buy an exchange-traded product that tracks the VIX. Its price rises and falls with the VIX. You can buy such a product if you anticipate a rise in the VIX, then sell when the price goes up.

Historically, another product called the XIV moved in the opposite direction to the VIX. If you anticipated the VIX will drop, you could make money by purchasing the XIV before it did so. However, the XIV was shut down in 2018 during a burst of volatility that saw its investors lose money.

That's a good reminder to remember to do your due diligence on any investment, perhaps especially one specifically tied to market volatility. Understand not just under which circumstances you stand to make money but when you can lose money and how much you can stand to lose. Ensure that you'll still be in a good financial place even under poor market conditions.