Chicago is known as the home of the blues. For investors hoping to profit from current market turmoil, it's the home of the VIX.
The Volatility Index, also known as the fear gauge, was established in Chicago, the epicentre of the global options market. The VIX seeks to measure volatility using call and put prices in S&P 500 options. The options market is complicated, but calls and puts are basically bets on the future price of stocks. The VIX turns those bets into a forecast of how those expectations jive with reality. When they don't jive, and reality hits, you get the sort of volatility we've been seeing lately.
Investors can't trade the index directly but some exchange-traded funds, or ETFs, that track the VIX have more than doubled in price in the past six months.
How the pros play the VIX
Chicago is also home to Stutland Volatility Group LLC, a financial firm that finds ways to profit from volatility through complex options trades. Business is booming thanks to recent wild market swings prompted by a faltering Chinese economy and the collapse of crude oil prices.
"Volatility is starting to become normalized," says Stutland chief investment officer Luke Rahbari. "Right now I don't see everything in the world being okay again and volatility going back to previous levels."
For nearly four years the VIX has been well below the historic average of 20, which indicates normal to low volatility. Last August, as equity markets experienced huge declines, it topped 40 and has since been registering just under 30, which is still considered volatile.
Unlike most investments, when you invest in the VIX it doesn't matter if markets go up or down; you make money when markets are volatile, and you don't when they are calm.
However, Mr. Rahbari says there is one crucial characteristic the VIX shares with other investments: timing. "If you time it right and volatility goes up, you're going to make money. If you don't, you lose money. It's no different than any other instrument," he says. "Just because it's high doesn't mean it's not going to stay high, or go higher."
He calls the risk involved in trading the VIX "the volatility of volatility" and says it's hard to know when calming events will occur. "Let's say the market was down 400 points and you bought a VIX ETF today and China came out with a stimulus plan tomorrow. That VIX ETF is going to crash 10 or 15 per cent in a couple of days."
He says VIX ETFs are ideal for trying to hedge risk in specific parts of an investment portfolio, but it's not easy. "You have to realize the correlation of these ETFs to the actual VIX and how it correlates to your portfolio," he says. "You have to do it along with some risky assets. If the market does go up and those risky assets go up, your VIX hedge goes down, but you're up over all."
VIX ETFs in Canada
In Canada, Horizons offers three Canadian-dollar-hedged, VIX-related ETFs:
- The Horizons Betapro S&P 500 VIX Short Term Futures ETF (HUV) attempts to track the VIX directly. Since it is hedged to the falling Canadian dollar it has only gained in value by 74 per cent since August compared with U.S. dollar VIX ETFs, which doubled in value over the same time.
- The Horizons Betapro S&P 500 VIX Short Term Futures Bull Plus ETF (HVU) attempts to double the performance of the regular Betapro VIX ETF. It hasn't doubled the regular Horizons VIX ETF but it has doubled in value since August.
- The Horizons Betapro S&P 500 VIX Short Term Futures Inverse ETF (HVI) attempts to track the opposite of the regular VIX ETF. In other words, it attempts to short the VIX in Canadian dollars. It is down 63 per cent since August.
Use with caution
Mark Yamada, president and chief executive officer of Toronto-based PUR Investing, specializes in creating ETF portfolios for clients. He says he has been seeing a lot of interest in VIX ETFs lately, but would only recommend them to investors who understand how they work.
He says securities regulators have become so concerned that retail investors might be getting in over their heads, they have clamped down on sales of the bull plus ETF – which attempts to double the performance of the VIX. "Advisers have to jump through hoops to get their clients permission to use them. The leveraged ones are targeted only for professional use."
He considers VIX ETFs to be short-term hedges for a specific purpose. "Owning VIX for a long time as part of a diversified portfolio doesn't make a lot of sense because of the cost of that hedge."
He says there are better alternatives on the options market for investors wanting to protect a position. "There are other ways of getting protection in a portfolio. Buying puts, for example, can be a more direct way."
Mr. Yamada says all retail investors can benefit from the VIX without the risk by using it as a gauge for other investment decisions. "The VIX is a good indicator of tension in the marketplace. Whether they actually want to buy or sell VIX is less important than what VIX is telling people."