Why Buying the VIX May Be a Risky Bet

While these returns may be tempting, especially given the high level of global economic uncertainty, the volatility index has actually trended sharply lower throughout 2014 and 2015 despite the high level of perceived uncertainty.

The CBOE Volatility Index – or VIX – measures the implied volatility of S&P 500 index options over the coming 30-day period. While this value is easy to calculate, investors looking to profit from changes in the VIX must rely on futures contracts to extract value. These contracts deliver cash based on the value of an index at a specified delivery date. For instance, a June futures contract is on 30-days of implied volatility with a June expiration date.

The problem with futures contracts is that they are subject to contango – a scenario in which the futures price is higher than the current price. When it comes to the VIX, there’s a rich history of futures contracts being in a state of contango. Investors or funds buying these contracts are paying a premium every time they purchase futures in these cases, which may be eroding their investment over time by “buying high and selling low.”

The VXX continuously rolls over one-month and two-month futures contracts to target a constant weighted average futures maturity of one month. In general, investors purchasing this ETN are predicting that volatility will increase over the coming month relative to the current month, but contango in the futures contracts suggests that the performance may be less than the benchmark VIX index.

The primary driver behind the VIX’s rise has been a combination of plummeting crude oil prices, a weakening Chinese economy, and uncertainty over the Federal Reserve’s plans to continue hiking interest rates. Over the coming months, investors must ask themselves whether these problems are poised to get worse, stabilize to an extent, or dramatically improve. The first and last scenarios could drive the VIX higher, while stabilization could send it lower.

There are signs that the crude oil market could be stabilizing, with Russia’s move to stem the price decline and Saudi Arabia’s openness to working in conjunction with OPEC members to cut supply. Meanwhile, China’s economy has shown some signs of stabilization that could mark an end to its equity market turbulence. While the economy is certainly slowing down, its domestic services economy could help it avoid the “hard landing” that some are expecting.

On the other hand, the S&P 500 continues to trade with a price-earnings multiple of over 21x, compared to its roughly 15x mean dating back to the 1900s. The current sell-off may be overextended on a technical level, but fundamentals would suggest further losses. For VIX investors, the big question is whether these losses will accelerate from the current downturn or come over a longer period of time under more stable conditions.

The CBOE Volatility Index (VIX) measures the implied volatility of S&P 500 index options, and futures contracts on the index have become increasingly popular. With the recent drop in equities, many investors have eyed shares of the iPath S&P 500 VIX Short Term Futures ETN (VXX A-) and the Credit Suisse VelocityShares Daily 2x VIX Short Term ETN (TVIX C+) to capitalize on the volatility at a time when equities are moving lower.

Despite these movements, investors should tread carefully when it comes to investing in VIX-aligned ETFs and ETNs. These instruments rely on futures contracts that could be disadvantaged during times of contango, while future volatility could even out over the coming months for fundamental and technical reasons. It’s important to be aware of these market mechanics and risks before leveraging these ETFs to hedge against rising volatility.