Volatility, Anyone?

If you surveyed investors, the majority would probably tell you they want nothing to do with stock market volatility. That’s because all of the ups and downs associated with investing in stocks can be emotionally stressful and even frightening as people watch the value of their investments bouncing around.

Adding to this truth is the launch of ETFs including the iShares MSCI USA Minimum Volatility ETF (USMV), PowerShares S&P 500 Low Volatility ETF (SPLV), Direxion S&P 500 RC Volatility Response Shares (VSPY) and others like them that aim to reduce the influence of market gyrations. This fairly new breed of volatility-killing ETFs has been a hit with investors and already amassed almost $12 billion in a span of just two years.

In reality, the financial services industry has conditioned the investing public to view stock market volatility as an enemy rather than an opportunity. Does it ever make sense to own volatility instead of avoiding it? How can advisors use market volatility as a profit opportunity?

VIX 101

The CBOE Volatility Index, or VIX, was launched in 1993 and is the go-to gauge for measuring stock market volatility of the S&P 500 by using index options prices.

The VIX is quoted in percentage points, and converts roughly to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For instance, a VIX of 13 means the market expects the S&P 500 to swing up or down 13% on an annualized basis over the next 30 trading days.

Although it’s impossible to invest directly in the VIX, advisors can obtain exposure to it by using VIX futures contracts, call/put options and VIX-linked ETPs. Let’s examine the latter.

Volatility ETPs

If you’ve ever traded in volatility, you’ve personally experienced or are at least aware of the performance discrepancies between the CBOE S&P 500 Volatility Index and VIX ETPs like the iPath S&P 500 VIX ST ETN (VXX).

The latest prospectus (dated July 31, 2013) for the ProShares VIX Short-Term Futures ETF and the ProShares Ultra VIX Short-Term Futures ETF (UVXY) alludes to some of the problems with getting VIX exposure via ETPs by saying: “High volatility may have an adverse impact on the VIX Funds beyond the impact of any performance-based losses of the underlying indexes, especially the geared (or leveraged) fund may perform differently than the Short-Term Index.”

Further: “The VIX Funds are benchmarked to the Short-Term Index. They are not benchmarked to the VIX or actual realized volatility of the S&P 500. The level of the Short-Term Index is based on the value of the relevant futures contracts (‘VIX futures contracts’) based on the Chicago Board Options Exchange Inc. (‘CBOE’).”

Here’s one expert’s view: “Traders need to remember that VIXY gives you exposure to the front two-month VIX futures contracts. There can be a disconnect in the performance between VIX futures and the VIX index that results in different performance out of VIXY and VIX,” said Russell Rhoads, CFA, an instructor with the Options Institute at the Chicago Board Options Exchange and author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics (2011, Wiley).

Put another way, VIX ETPs don’t necessarily track the VIX index itself; buyer beware.