VIX ETFs Broadcast Lingering Market Volatility

by: Tom Lydon

The recent upswing in market volatility has also caused exchange traded products following CBOE Volatility Index futures to rise. An elevated VIX means investors should strap in for a rocky ride, analysts say.

The VIX, which measures implied market volatility based on S&P 500 options, dropped below 40 in Tuesday’s market rally after nearly touching 50 earlier this month.

The $1.2 billion iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) is the largest volatility-linked product. It lost about 5% on Tuesday but has spiked this summer.

“Markets are more fearful of financial turmoil than pretty much anything else mankind can throw at them,” said Nicholas Colas, chief market strategist at ConvergEx Group. “This means that as long as investors wonder aloud about the solvency of large American and European banks or the sustainability of the euro, it will be a bumpy ride.”

Since October 2008, the average for the VIX is 28, with a standard deviation of 13, so the volatility index isn’t “unusually high” until around 54, Colas wrote in a recent note.

Also, buying stocks when the VIX spikes above this level doesn’t guarantee immediate profits. For example, three months after the VIX peaked at 80 in late 2008, the S&P 500 was essentially unchanged, the strategist pointed out. “It took a year to generate a 25% return,” he added.

Investors can use exchange traded funds and notes tracking VIX futures to hedge portfolios or speculate on volatility. However, it should be stressed that volatility-linked ETFs follow VIX futures rather than the spot price. The VIX essentially measures the cost of options-based “insurance” over the next month.

“The ‘background noise’ of financial risk seems to have increased since 2008, meaning that the VIX is probably not overbought until it gets into the 50s,” Colas wrote. “Even if you do buy risk assets as the VIX crests over 50 (or 60, or 70, or even 80), you are likely in for some volatility in the months after that theoretical peak in the VIX. As highlighted, buying the U.S. equity market as the VIX printed 80 in October 2008 did yield a profitable return. But it was not quick or easy.”

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Source: ConvergEx

Max Chen contributed to this article.

Disclosure: None