Understanding VIX and its ETFs

In mid-July 2024, the U.S. stock market was on a roll, with major indices hitting record highs. But in less than a month, everything changed. The first three trading days of August brought a "triple whammy" to investors, with the $S&P 500 Index (.SPX.US)$ and $NASDAQ (200302)$ both taking a nosedive.

Meanwhile, $CBOE Volatility S&P 500 Index (.VIX.US)$ , the CEOE Volatility Index, also known as the "fear gauge," skyrocketed by an astonishing 108.03%.

So, what is VIX, and why is it so important? And how can you invest in it to potentially benefit from market volatility? Let's dive in and explore.

What is VIX? Does a rising vix mean the stock market will crash?

VIX refers to the S&P 500 Volatility Index. This index measures the market's expectations for volatility over the next 30 days, derived from the real-time prices of S&P 500 at-the-money (ATM) put and call options.

ATM option prices are considered indicators of market volatility. When unexpected events cause market panic, investors tend to buy options, driving up their prices. This is why the VIX is seen as a gauge of fear and anxiety in the U.S. stock market.

The VIX value is expressed as an annualized volatility percentage. For example, if the VIX is at 17, it indicates an expected annualized volatility of 17%, which translates to a 4.9% volatility over the next 30 days (17% ÷ √12 = 4.9%).

A higher VIX suggests that investors expect greater market fluctuations ahead. However, market volatility can go both ways: a rising VIX doesn't necessarily mean the stock market will decline.

Historical trends show that when the VIX spikes, the S&P 500 often performs poorly. For instance, during the 2008 financial crisis, the VIX surged to nearly 90 within two months. Similarly, in the wake of the COVID-19 pandemic in 2020, the VIX shot up past 80.

Typically, when the VIX rises, market sentiment is bleak; conversely, when it falls, the market tends to recover. This correlation is why the VIX is known as the fear gauge

How to understand VIX

When the VIX index rises, it signals growing market anxiety. A sharp surge often means the market is facing significant disruptions like war, financial crises, or major disasters, leading to a quick downturn. During these times, panic selling is common, which value investors might see as a "buying opportunity" under the mantra "be greedy when others are fearful."

On the other hand, when the VIX falls and stays low, it indicates a stable market with general optimism about the future, though it can also lead to investor complacency.

Historically, the VIX usually fluctuates between 10 and 30. Analysts often use 30 as the benchmark for high volatility and market panic. A VIX below 20 typically signifies a stable market, while a VIX under 15 might suggest a market bubble.

Some investors believe the VIX index can help predict short-term tops and bottoms of the S&P 500 index. When the VIX reaches extremely high levels, it suggests the S&P 500 might have hit a bottom, serving as a potential bullish signal. Conversely, when the VIX is at extremely low levels, it indicates the S&P 500 might have reached a short-term top, serving as a potential bearish signal.

However, it's essential to note that the VIX doesn't always perfectly reflect market direction. There can be instances where the market declines without a significant increase in volatility.

Investing in VIX ETFs: thriving in market chaos

Since the VIX index often moves inversely to the stock market, many investors use VIX-related tools to diversify, hedge risks, or speculate in the short term.

While you can’t invest directly in the VIX, you can use ETFs, futures, and options. For stock investors, ETFs are usually the easiest to understand and use.

Moomoo makes it easy to find and identify volatility-related ETFs, including leveraged and inverse options, to fit your investment strategy.

These ETFs track market volatility by holding VIX futures contracts. Because futures contracts have expiration dates, the fund managers must continually sell cheaper near-term contracts and buy more expensive long-term ones. This process incurs costs that affect the ETF's net asset value.

For example, take UVXY. In the short term, UVXY can mirror the VIX's movements. However, over a longer period, UVXY tends to trend downward due to these costs.

For instance, from January 3 to August 2, 2024, the VIX index rose by 77.20%, while UVXY fell by 7.43%. This indicates that volatility ETFs like UVXY are more suitable for short-term trading rather than long-term holding.

In addition to UVXY, high-volume options include $ProShares VIX Short-Term Futures ETF (VIXY.US)$ , $2x Long VIX Futures ETF (UVIX.US)$ , and $iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX.US)$ , none of which pay dividends. How should you choose between them? The chart below compares these four ETFs across five key dimensions to help you decide.

Among the listed options, VXX has the largest asset size, with a total expense ratio of 0.89%. However, it's important to note that VXX is actually an Exchange-Traded Note (ETN). While similar to ETFs, ETNs don't hold underlying assets, which makes them fundamentally different and potentially riskier to trade.

If you want to learn more about ETNs, you can watch this video course: What are the different types of ETFs?

Investing in inverse volatility ETFs: likely perform better in stable markets

In addition to long volatility ETFs, the market also offers inverse volatility ETFs, which perform better when the U.S. stock market remains in a low-volatility range. Examples include $SIMPLIFY VOLATILITY PREMIUM ETF (SVOL.US)$ , $ProShares Short VIX Short-Term Futures ETF (SVXY.US)$ , and $-1X SHORT VIX FUTURES ETF (SVIX.US)$ .

These ETFs achieve their inverse volatility objectives by buying or selling VIX futures contracts and options, each with distinct investment goals:

$SIMPLIFY VOLATILITY PREMIUM ETF (SVOL.US)$ : Aims for 0.2 to 0.3 times the inverse daily performance of the short-term VIX futures index.

$ProShares Short VIX Short-Term Futures ETF (SVXY.US)$ : Targets 0.5 times inverse leverage.

$-1X SHORT VIX FUTURES ETF (SVIX.US)$ : Aims for 1 times inverse leverage.

Due to these different goals, each ETF has unique strategies and holdings. Their performance over the past year (from July 31, 2023, to July 29, 2024):

$SIMPLIFY VOLATILITY PREMIUM ETF (SVOL.US)$ : Increased by 14.53%

$ProShares Short VIX Short-Term Futures ETF (SVXY.US)$ : Increased by 34.39%

$-1X SHORT VIX FUTURES ETF (SVIX.US)$ : Increased by 43.52%

$S&P 500 Index (.SPX.US)$ : Increased by 19.23%

(*Note: SVXY underwent a 1-for-2 stock split on April 11, 2024. The historical performance was adjusted accordingly.)

We can learn that SVIX offers the highest inverse leverage and best performance but also has the largest drawdowns, while SVOL provides the smallest inverse leverage, trailing the S&P 500 in the past year but featuring the least drawdown and monthly dividends.

In conclusion, each ETF has its own characteristics, and investors should choose based on their personal strategies and needs. However, as a rule, these inverse ETFs are not suitable for long-term holding and are better suited for experienced investors due to their reliance on daily performance and inherent risks of leverage.

Things to consider when investing in VIX ETFs

Investing in inverse VIX ETFs comes with significant risks. Historical data shows that when market volatility spikes, these ETFs can collapse or even be delisted:

In February 2018, the inverse VIX ETN XIV plummeted over 90% in one trading day and was subsequently delisted. At its peak, XIV had assets totaling $2.2 billion.In June 2020, during the COVID-19-induced market crash, issuers removed three VIX-related ETFs from the market to prevent another XIV-like disaster.

Therefore, investors need to respect the market's unpredictability. The VIX index reflects short-term market volatility and is not a direct inverse of the S&P 500 index. Market volatility fluctuates and eventually returns to normal levels. Therefore, VIX ETFs, along with related futures and options, are unsuitable for long-term investments. When trading volatility-related products, stay vigilant, monitor market conditions, and be prepared to cut losses promptly.