Bracing for Volatility: What is the VIX and How Can Investors Profit With It?

Joe Goldman |

roller coasterThe Volatility S&P 500 (VIX) is an implied volatility index that is traded on the Chicago Board Options Exchange (CBOE).  The index is designed to estimate the expected volatility of the S&P 500.

The price movement and volatility of S&P 500 options determines the value of the VIX.  If investors expect market volatility to increase, the VIX will go up in value.
  
As a result, the VIX is widely referred to as the “fear index” or “fear gauge.”  When investors become fearful, market volatility heightens and the VIX rises in value – sometimes significantly.

During the Great Recession, many investors feared that the U.S. economy was headed for a depression. Fear was at its highest level in decades and as a result, the VIX rose from $19.43 on August 28, 2008 to $80.06 on October 27, 2008.  This represented a gain of over 400 percent in only two months.

More recently, investors have grown bullish on the economy. With talks of a double-dip recession off the table for now, the VIX has fallen from $48.00 in August 2011 to the low teens in spring 2013.

So how can investors profit from the VIX?

The easiest way to trade the VIX is through exchange-traded funds (ETFs).  The most heavily traded is the iPath S&P 500 VIX ST Futures ETN (VXX), which moves in direct correlation with short-term VIX futures.  Traders can also use inverse ETFs such as the XIV, which goes up when the VIX goes down.

While these ETFs should never be held for extended periods of time and are far from perfect indicators of the actual performance of the VIX, a VIX ETF can serve as a decent hedge against a risky investment.  If an investor feels overly invested in stocks in the near term, the VXX can serve as an excellent insurance policy against a market correction because it will rise a when market sentiment turns negative.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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