VIX Trading Tools

The CBOE Volatility Index, or VIX as it is commonly known, is a complicated animal. First of all, it’s a derivative of a derivative.

Say what? Yep, the VIX is calculated from the implied volatility of S&P 500 index options traded at the Chicago Board Options Exchange (CBOE).

In other words, the VIX is derived from options trading that is derived from the price movement in the underlying stock index.

But if you think that’s complicated, listen up because it gets more interesting. As markets evolve and new risk management innovations come to the surface, one of the most common is to have futures markets on just about any traded asset.

Gold, crude oil, wheat, copper, soybeans, currencies and bonds all have their own futures contracts. So why shouldn’t the VIX?

Enter the 3^rd and 4^th Derivatives

With VIX futures, we now have derivative #3 in our chain from the S&P 500 index.

And what innovation comes next? ETPs of course. ETP stands for Exchange-Traded Products because there are Exchange-Traded Notes as well as conventional ETFs.

Here’s the name and description of the most popular VIX-based ETP, taken from the instrument sponsor’s website…

The Barclays (LON:BARC) iPath S&P 500 VIX Short-Term Futures Index TR ETN (VXX) is designed to provide investors with exposure to the S&P 500 VIX Short-Term Futures Total Return Index.

Got that? There’s your 4^th derivative in our chain. Or is it now a tangled web?

And it gets even more interesting with ETPs that apply leverage to the situation, like the ProShares Ultra VIX Short-Term Futures ETF (UVXY) which seeks daily investment results, before fees and expenses, that correspond to two times (2x) the daily performance of the S&P 500 VIX Short-Term Futures Index.

What’s Wrong With a 4^th Derivative?

The problem with these VIX-based ETPs is that they are destined to go to zero because of a force in futures markets called “contango” where further out expirations trade at higher prices than near-term expirations.

What contango creates is a situation where these short-term vehicles must always sell the near-term VIX futures before they expire and pay up to buy the next month. It’s like an extra fee or built-in tax. And it acts like gravity on the value of the ETPs.

To keep from going all the way to zero, these ETPs must occasionally do a reverse split to get their share prices back up high enough, for another year or so of gravity.

The VXX product likes to do 1:4 reverse splits and has done about 4 of them since inception, coincidentally just over seven years ago around the time of the bear market lows in 2009. Look at a ten-year chart and you’ll see that because of these reverse splits, the all-time high is now $30,000!

VIX Knowledge: Your Weapon Against Money-Draining Derivatives

To make sure you understand what’s going on here, I have two resources to recommend. First is the set of tools mentioned in my title. It can be found at www.VIXCentral.com where Eli Mintz has a graph of the VIX futures term structure (much like an interest rate yield curve term structure).

His website pulls data from the CBOE and updates every minute. VIXCentral has lots of ways to look at the VIX and its derivatives that are useful to stock index traders even if one is not actively trading volatility.

But it does not have information on the derivative ETPs. All you need to know there is that the picture you see of upward-sloping VIX futures contracts (contango) is what is driving the value of VXX and UVXY down every day when the markets are relatively stable.

In the video that accompanies this article, I give a quick tour of the VIXCentral website and highlight some of its key features and tools.

I also highly recommend my article and video from last year on the basic ingredients of the VIX like standard deviation and implied volatility. I cover some other silly practices that zodiac-loving traders promote like doing technical analysis on the VIX chart. You can find my rant here…

Trading the VIX: What You Need to Know

Kevin Cook is Senior Stock Strategist for Zacks Investment Research where he runs the Tactical Trader service.