Will a Warming VIX Cool Off Before Summertime?

VIX, the Chicago Board Options Exchange Volatility Index, spiked higher again on Friday to continue its meteoric May performance.

ON Friday, major U.S. stock indexes suffered declines in the 2-3% range, and not surprisingly, VIX, also known as the “fear indicator,” jumped 11% to close at 26.66%, a level last seen in late 2011.  For May, the indicator jumped 55% as fear re-entered global markets.

In spite of all the recent action in volatility, VIX could still have some distance to rise as today’s levels are still relatively modest by historical standards.

In the chart above, we can see how VIX peaked in the mid-40s during the last two summers’ declines and reached stratospheric levels in the 80s during the financial crisis of 2008.

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While recent moves have been impressive, VIX still remains below 30 which is the widely watched level that indicates real panic is setting into markets.  Since VIX moves inversely to stock prices, professional traders and institutional money managers will be watching closely to see if VIX moves above 30 over the coming weeks which could foretell the future of today’s ongoing stock market correction.

For investors, VIX ETNs offer a way to participate in the volatility market without having to enter the esoteric world of options or futures trading.

Two of the most popular and widely traded VIX ETNs are:

iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX): This ETN is designed to track volatility in the markets as measured by the Chicago Board Options Exchange Market Volatility Index (CBOE Index), a popular measure of the implied volatility of S&P 500 index options.  The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) prices itself off of the average and implied volatility of the first two months of futures contracts of the S&P 500 Index.

Velocity Shares Daily Inverse VIX Short-Term ETN (NYSEARCA:XIV): This ETN is designed to inversely track the volatility in the markets as measured by the S&P 500 VIX Short-Term Futures Index.

When VIX is in a rising trend as it is now, the ETN of choice would be (NYSE:VXX) while (XIV) would be the way to bet on a falling VIX.  Both of these ETNs do not track VIX directly but rather the underlying futures contracts and so they can have significant tracking difference from the VIX index, itself.

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Using any of these ETNs requires a well thought out trading plan and significant discipline because fast gains can be fun but these can move equally quickly against you and generate large losses if careful risk management techniques are not employed.  Also, the tracking error inherent in these products can work against you and so you must be fully familiar with the prospectus and characteristics of these products before venturing into these waters.

What happens next to global stock markets and to VIX is an unknown, of course, as no one has a crystal ball or can reliably forecast what will happen this month as Spain struggles with its debt, Greece hurtles towards its pivotal June 16th election and Dr. Bernanke meets with his colleagues to mull over the world economy and plan his next moves on June 19-20.  What is almost certain, however, is that VIX and VIX ETNs will continue to move in opposite directions to the S&P 500 as fear rises and falls in the markets and that knowledgeable investors will be able to use these sophisticated ETNs to seek profits in today’s high velocity markets.

John Nyaradi is the author of The ETF Investing Premium Newsletter.

Disclosure: ETF Investing Premium holds a position in iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX).