The global COVID-19 outbreak has sent global stock markets into chaos. With massive drops followed by huge rebounds day after day, volatility has become an ever-present force that investors have to manage.
Many investors are looking for ways to turn volatility into profit. The CBOE Volatility Index, also known as the VIX, has become a key measure of just how panicked some investors are getting, but investors are also using the benchmark in more active ways as part of their overall investment strategies. Below, we'll look more at the VIX and why you should understand the role it can play in your portfolio.
What is the VIX?
The CBOE Volatility Index looks at the options markets to determine how much volatility market participants expect in the near future. By looking at different options and their prices, Cboe Global Markets (NYSEMKT:CBOE) is able to calculate a number that investors are implicitly using to guide their options trading. The higher the number, the more volatility investors expect.
Yet you don't have to be an options trader to get valuable information from the VIX. Some investors call the VIX the Fear Index, because it tends to rise during market crashes and fall back during better times for the stock market.
Ways to play the VIX
In addition, investors have come up with ways to make money directly from moves in the CBOE Volatility Index. The exchange-traded iPath S&P 500 VIX Short-Term Futures (NYSEMKT: VXX) seeks to track the VIX by holding futures contracts linked to the volatility benchmark, and from Feb. 20 to March 13, it has more than tripled.
If you're aggressive and like risky plays, you can get even more exposure to the VIX. The ProShares Ultra VIX Short-Term Futures (NYSEMKT:UVXY) has more than quintupled during the same period, because it has a share price that seeks to provide leveraged exposure of 1.5 times the movement in VIX futures.
What every volatility investor has to be careful about
Unfortunately, there are a lot of pitfalls when you invest in volatility. They include:
- Being on the wrong side of the volatility trade can be devastating to your portfolio. For instance, ProShares Short VIX Short-term Futures (NYSEMKT:SVXY) is designed to move higher when the VIX moves lower. It's lost more than half its value between Feb. 20 and March 13, and it could see even bigger losses if volatility spikes further.
- Volatility investments are designed to be short-term in nature, with returns tied to daily changes in the VIX. Over longer periods of time, owning volatility-linked investments has been a terrible bet. The iPath volatility product, for instance, lost money every year from 2009 to 2017, posted a small gain in 2018, and then plunged by two-thirds in 2019.
- Because of their design, it's possible for both long volatility and short volatility investments to lose value over time.
- Big swings can move in either direction, and they can be fast and furious. In early 2018, all it took was a single day of spiking volatility to wipe out one leveraged short-volatility fund.
Worth the risk?
All of these risks are hard to see when the prices of volatility-linked investments are shooting through the roof day after day. Yet as with many stocks and ETFs that get popular for a short time before falling back to earth, investing in volatility tends to bring long periods of losses punctuated by only occasional bursts of glory like we've seen recently.
At this point, many of the gains for volatility ETFs have already gotten factored into their prices. Volatility could indeed keep going higher. Yet when markets calm down, volatility investors will find out the hard way just how quickly their investments can reverse lower -- even as high-quality stocks are proving their long-term value.