Trading the VIX: Strategies for Profiting from Market Volatility

Trading the VIX refers to buying or selling Volatility Index (VIX) based futures or options contracts. It is quite a lucrative way to make money using market volatility. However, it is crucial to understand that trading the VIX is substantially risky as well as complicated. It involves significant risks and comes with complications that beginners may find overwhelming to understand. Therefore, one thing is for sure and that is “it isn’t suitable for all types of investors”.

That being said, if you still want to trade it, it’s crucial to learn all about it before trading the VIX. You need to understand how to trade the VIX effectively. Therefore, we are going to help you by explaining in this article how to profit from market volatility using the VIX. Let’s begin right away.

What is the VIX

The Chicago Board Options Exchange Market or CBOE Volatility Index, simply known as VIX is a measure of expected volatility. More specifically, it gauges the market’s sentiment or measures the expectations of the market regarding future volatility. How does it do so? It does so by tracking the prices of options on the S&P 500 index. Thus, it gives investors an idea about the volatility in the market over the next 30 days.

Typically, the VIX tends to increase when uncertainty or turmoil increases in the market. Therefore, it is also referred to as the “fear index.” Now, investors can use the VIX in two ways. Firstly, they can use it as a measure of market sentiment. Secondly, they can also use it as a strategy to hedge their portfolios against adverse market movements.

Moreover, when it comes to understanding the values of the VIX, it is quite simple. For instance, high values suggest that investors are expecting the market to be more volatile. Conversely, low VIX values indicate that investors are expecting the market to be less volatile. Thus, they can adjust their positions accordingly using these VIX values.

Trading the VIX

As we mentioned at the beginning, trading the VIX is complex and challenging. However, there are some effective strategies that you can employ to capitalize on the market volatility.

Strategies for trading the VIX

Here are some effective strategies for trading the VIX.

Convergence-divergence relationship

The convergence-divergence relationship is one of the most important strategies to trade the VIX. Basically, it is a relationship between the VIX and the S&P 500 index. Typically, the VIX tends to rise with a falling S&P 500 index. Whereas, the VIX tends to decline with the rising S&P 500 index. Thus, there is a relationship that we can call convergence. This is because the VIX and the S&P 500 move in opposite directions.

Contrarily, the S&P 500 index may also stay relatively flat or move within a narrow range. In such cases, the VIX may remain stable or it may move in the opposite direction. As the VIX and the S&P 500 is not moving in the same direction, we can name this relationship as divergence.

Now, you can use this convergence-divergence relationship in trading the VIX strategies. For instance, you can go for the “long S&P 500, short VIX” strategy. It involves taking a long position in the S&P 500 when the S&P 500 index rises while the VIX is falling.  Additionally, the strategy also needs you to enter a short position in the VIX simultaneously.

However, it is also a fact that the convergence-divergence relationship may not always be consistent. In other words, you may experience situations where you find the VIX and the S&P 500 moving in the same direction. Or, it may well be possible that you may find the VIX not responding to changes in the S&P 500 index as you expected. Therefore, you should understand and adjust your strategies to these nuances.

Instruments for trading the VIX

The following are some popular types of instruments you can use for trading the VIX.

1. ProShares VIX Mid-Term Futures ETF

ProShares VIX Mid-Term Futures ETF tracks the performance of the S&P 500 VIX Mid-Term Futures Index. It involves investing in a portfolio of VIX futures contracts that will mature between one to six months. Investors interested in this ETF seek to benefit from an increase in volatility while hedging against adverse market movements.

2. The ProShares VIX Short-Term Futures ETF

The ProShares VIX Short-Term Futures ETF also tracks the performance of the S&P 500 VIX Short-Term Futures Index. Firstly, it is for investors who prefer to capitalize on a short-term increase in market volatility. Secondly, it is for investors who seek a hedging tool to protect their portfolio from downside risk. Typically, the values of these ETFs rise when the VIX increases. Whereas, values fall when the VIX decreases.

3. The iPath Series B S&P 500 VIX Mid-Term Futures ETN

The iPath Series B S&P 500 VIX Mid-Term Futures ETN tracks the performance of the S&P 500 VIX Mid-Term Futures Index. Barclays Bank issues this Exchange Traded Note. These ETNs provide investors with exposure to the mid-term VIX futures market, typically up to 5 to 7 months. Simply put, this instrument is for investors who believe that the VIX will rise in the mid-term.

4. iPath Series B S&P 500 VIX Short-Term Futures ETN

iPath Series B S&P 500 VIX Short-Term Futures ETN tracks the performance of the S&P 500 VIX Short-Term Futures Index. It consists of VIX futures contracts whose values increase with the rising VIX. Moreover, it is also for a short period of time and is only for traders seeking profit from a short-term increase in volatility.

The wrap-up

Trading the VIX is lucrative for most investors, especially for those who want to hedge against market volatility. This is because the VIX tends to rise when uncertainty increases in the market. However, trading the VIX is risky and complex. The highly volatile nature of the index makes it very risky. Additionally, it is also prone to unexpected changes in direction. Therefore, it is of paramount importance to know all about VIX. In addition to this, you should also understand the dynamics of the underlying market. Only then it is possible to effectively trade the VIX.