Understanding The Risks Involved With Trading The CBOE Volatility Index

 |  Includes: VIXY, VXX
by: Kevin M. O'Brien

Ever since the economic meltdown in 2008, the Chicago Board Option Exchange (CBOE) volatility indicator for the S&P 500 (VIX) has gained a lot of popularity among traders trying to capitalize on the wild market swings. Yes, volatility is back. This doesn't mean you have to trade volatility itself. You will be much better served using this volatility to invest and trade in stocks or ETF's.

The CBOE S&P 500 Volatility Index basically behaves like this: when the S&P is up for the day, the VIX goes down. When the markets fall, the VIX spikes up.

I used to trade these instruments. Coming from experience, I can tell you that If you plan to trade this instrument on a daily basis, you will have little chance at succeeding. I'm sorry to sound so pessimistic about them, but it's just the way these options are constructed. My goal in this article is to have traders who are unfamiliar with the VIX understand what they are getting into.

I would like to point out that the CBOE's S&P 500 Volatility Index is a great tool to see where the fear level is in the markets. Having this index on a streaming chart daily can provide very useful and invaluable information for active traders looking to get in and out of positions.

As far as trading these instruments for profit, I recommend to steer clear of them unless you are a very savvy and experienced prognosticator in how the markets will play out months in advance, and one who also understands their pricing. You must also be willing to risk a potentially massive loss. The investment, in my opinion, is simply not worth the risk.

One of the many issues that many new traders fail to realize with the VIX is that the options available on them do not move in tandem with current market conditions.

Unlike a normal call or put option where you can figure out what price an option will increase or decrease based on the price of the stock, the VIX is a completely different animal alltogether. Many traders are surprised and often angry when the market is moving favorably to the side of their position on the VIX, yet the price of their options are not reacting to this. This is because the pricing of them is based on the two front months of the S&P 500 Futures contracts. This issue alone is why I do not recommend trading them. It is very hard to gauge the value of your options using them and when you will be able to exit the trade for profit.

One of the best explanations you will find about the VIX and the pricing of them on the internet is by Peter Lusk, an instructor at the Options Institute, which is based in Chicago. Please see this short, but excellent, video by Peter.

One other issue is that for some traders, the VIX Futures prices are not readily available to view. This really represents a problem, especially for novices not familiar with pricing them. When I buy options, I like to know what kind of price movement in the underlying stock will result in a profit so I can exit the trade when need be. The VIX does not make this easy to do.

There are other volatility indicators such as the Pro Shares VIX Short-Term Futures ETF (NYSEARCA:VIXY) and the iPath S&P 500 Short-Term Futures ETN (NYSEARCA:VXX) which can be traded. These two will move more in conjunction with where the S&P 500 is currently trading at. Liquidity on these two are anemic, however.

As I stated earlier, the CBOE S&P 500 Volatility Index has many uses for an investor or trader looking at current and near-term market conditions to find entry and exit points. For that purpose, the VIX can be a very helpful tool in conjunction with other indicators. However, please understand the risks and factors involved with trading them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.