Market uncertainty creates volatility and the VIX is an index that measures this volatility based on the S&P 500. When news hits the stock market, the VIX increases and when there are fewer outside factors or less uncertainty about the future, we see the VIX fall.
Thus far, in 2020, we have had two situations that have increased volatility in the stock market; the political and military situations between the United States and Iran and the Coronavirus. We are only one month into the year and two major events have occurred which have sent the VIX soaring higher. There will undoubtedly be more pop-up events such as say further political and military issues with Iran or even North Korea perhaps. We will likely see natural disasters pop-up which could cause uncertainty, the situation in England with Brexit and how that is handled could potentially cause uncertainty. Coronavirus is likely to continue to create uncertainty. These are just a few predictions off the top of my head that could cause the VIX to move in the coming months.
One event coming in 2020 that we can all see on a calendar is the Presidential election this year. We know uncertainty about the future causes the VIX to rise and based on the past election of President Donald Trump, we can confidently say that political polling is not very accurate. Thus, we can predict there will be a high level of uncertainty coming down the road with who may be our next President.
With all of this in mind, how do we use this uncertainty to make money? Well, the easiest way is by trading in and out of the VIX. When there is little uncertainty in the market, you would buy the VIX. When uncertainty jumps and the VIX increases, you sell it. Then sit patiently until the VIX falls and buy back into it. Rinse and repeat. This is a rather aggressive strategy since the VIX is priced based on options contracts and therefore, you will be a ‘daily’ fee in essence for merely holding the VIX.
This ‘daily’ fee isn’t one that will show up in your account like a charge, but the higher expense ratios of the Exchange Traded Funds which allow you to trade the VIX, will be one cost you need to consider. The other is difficult to pin down in terms of how much it will actually be because the fund will be using options and leverage in order to get you the exposure you are looking for in the market. To get that leverage, the fund will be resetting daily since it’s based on daily options contracts. Those daily resets cost the fund money and therefore, those costs will be passed on to the investors holding the fund by reducing the actual value of each share a little every day you own the fund.
ETFs that use options to gain leverage all warn investors that the fund is meant to be traded daily and not intended to be a long term holding because, over long periods, these daily costs can deteriorate the fund enough to offset what otherwise would be a massive return. What that means is you can pick a fund that increases by say 10% in one month, but the daily cost of owning that fund over that period could add up to more than 10%, so you would still lose money despite correctly predicting that the investment would go higher.
Since trading the VIX is going to be difficult because of the daily cost of owning a VIX ETF and not knowing when volatility is going to spike, you could take this all one more step and trade options contracts on different VIX ETF’s. The previous strategy is risky or aggressive because you can lose a substantial amount of money in several ways. However, this strategy of buying options on VIX ETFs is even more aggressive or risky because you are using options and therefore, you are in the simplest terms leveraging an already leveraged investment. I personally don’t recommend anyone doing this since the risk is so substantial.
Even without using options or the two big events which have caused the VIX to pop in 2020, the top VIX ETF’s are all down over the last 3 months by a lot. The VelocityShares Daily 2x VIX Short-Term ETN (TVIX) is down 49.36% over the previous three months, the ProShares Ultra VIX Short-Term Futures ETF (UVXY) is down 37.47% over the same timeframe and the iPath Series B S&P 500 VIX Short Term Futures ETN (VXX) is down 25.6%.
These are all extremely risky and volatile investments and not ones that should be used by the average investor, that is likely you reading this article. These products were designed to be used by major investment firms who are looking to reduce their downside portfolio exposure if and when the markets decline due to high uncertainty periods.
So next time someone in the media talks about the VIX moving higher, don’t think about how you missed out on an opportunity, think about what stock or unleveraged ETF you can buy during the dip in equity prices.
Disclosure: This contributor did not hold a position in any investment mentioned above. at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.