Wall Street has been extremely turbulent lately, and on Wednesday morning, investors got another case of the jitters. Focusing on all the things that could go wrong in the market, major stock indexes were poised to lose substantial ground when the market opens. In premarket trading Wednesday morning as of 8 a.m. EDT, futures on the Dow Jones Industrial Average (^DJI) were down 326 points to 33,857. Futures on the S&P 500 (^GSPC -0.09%) dropped 48 points to 4,286, and Nasdaq Composite (^IXIC) futures fell 186 points to 14,470.
Stock market volatility levels have been on the rise, and many investors are looking to protect themselves against further declines by looking to the options market. A key measure of volatility, the CBOE Volatility Index (^VIX 1.71%), has seen a couple of its biggest spikes all year come in the last couple of weeks. That has some investors looking for ways to profit -- and this morning, they're turning to exchange-traded funds designed to try to track the VIX.
Volatility ETFs and the VIX
The ETF universe has found ways to invest in nearly anything, and volatility is no exception. Because there's no way to invest directly in movements in the VIX, volatility ETFs concentrate on VIX futures contracts.
One relatively simple exchange-traded volatility product is iPath Series B S&P 500 VIX Short-Term Futures (VXX -1.88%). This security is designed to track the daily movements in the front month and second month VIX futures contracts. Given this morning's rise in anticipated volatility, shares of the iPath volatility product are up more than 4% in pre-market trading.
A similar product is ProShares VIX Short-Term Futures ETF (VIXY -1.66%). It uses a slightly different methodology in selecting futures contracts to achieve the same goal. It's also up nearly 4% as of 8 a.m. EDT Wednesday.
Those investors seeking an even larger gain from rising volatility levels can use leveraged volatility ETFs. The ProShares Ultra VIX Short-Term Futures ETF (UVXY -2.66%) offers moves that are 1.5 times the corresponding daily movement of various VIX futures contracts. That multiple has the ProShares fund up nearly 6% in the pre-market session Wednesday.
The dangers of volatility ETFs
Investing in volatility is dangerous. The first thing to keep in mind is that these products are all designed to tie to daily returns, and that makes them less than ideal for long-term investors. For instance, looking at the iPath's history, it lost money every single year from 2009 to 2017, eked out a tiny positive return in 2018, lost two-thirds of its value in 2019, and climbed just 11% in 2020's turbulent stock market year. It's down more than 60% so far in 2021.
However, the massive returns you can earn if you have perfect timing are tempting. From mid-February to mid-March in 2020, the iPath product jumped more than 320%. The ProShares Ultra volatility ETF gained nearly 700%. But you do have to have perfect timing on both ends -- by the end of April 2020, the funds had given back 50% to 60% of those gains. By the end of the year, the ProShares fund had actually dropped back to a net loss after its huge spike.
Because of their big daily moves, volatility ETFs are attractive to short-term traders. For long-term investors, though, the better way to play volatility is to have cash on hand to buy attractive stocks when they're cheap after a downswing. The bargains you'll reap can end up being top performers in your portfolio.