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The VIX Complex

The VIX is the most-watched volatility number in the world. It is also one of the most misunderstood. The complex of products built on top of it is bigger than most people realize.

15 min read · Lesson 14 of 24

What the VIX actually is

The VIX is a real-time index calculated by the CBOE that measures the 30-day implied volatility of SPX options. It is computed from a weighted strip of SPX call and put prices using a model-free formula. The output is annualized, in percentage terms.

If the VIX is at 16, the market is pricing in approximately 16% annualized SPX volatility over the next 30 days. Translated to a one-standard-deviation monthly move, that is roughly 4.6% (16% divided by sqrt(12)).

The VIX is not a price you can trade directly. It is a calculated index. To trade it, you use VIX futures, VIX options, or VIX-linked ETFs (VXX, UVXY, SVXY).

Why it is called the fear index

The VIX has a strong negative correlation with SPX. When SPX falls, the VIX usually rises. When SPX rallies, the VIX usually drops. The mechanic: when stocks fall, demand for puts spikes (people want protection), which pushes IV up, which pushes the VIX up.

Fig. 14.1 SPX and VIX moving inversely. The Day 35 selloff is mirrored by a sharp VIX spike. The relationship is statistical, not mechanical, but it is reliable enough to define the VIX's role in markets.

The correlation is not perfect. There are days when both move in the same direction. But over a long sample, the negative correlation between SPX returns and VIX changes is roughly −0.7 to −0.8. This is why VIX is sometimes used as a tail hedge proxy: long VIX positions tend to pay off when long stock positions are losing.

VIX futures

VIX futures are the primary way institutions trade volatility directly. They settle to a special opening quotation of the VIX on the morning of expiry. The futures curve usually shows the same contango/backwardation pattern as the underlying SPX option term structure (covered in L.13).

Most of the time, VIX futures trade in contango. The front-month future is below the second-month future, which is below the third-month, and so on. This means a short futures position rolling forward earns a small return as the future converges down to the spot VIX.

The combined return from being short the VIX future and rolling through contango is the engine behind products like SVXY (the inverse short-vol ETF). It works for years at a time. It can also unwind catastrophically during vol spikes.

VIX options

VIX options trade as European-style cash-settled options on the VIX index. They have their own quirks. The forward price for VIX options is not the spot VIX but the corresponding VIX future, because that is what they ultimately settle against.

This means VIX options can look strangely priced relative to the spot VIX. A 30-day VIX call may look out of the money compared to the current VIX level but be near the money relative to the 30-day future. Mispricing this is a common error for traders new to VIX options.

VIX options reference the future, not the spot

When trading VIX options, the relevant reference price is the VIX future expiring on the same date, not the spot VIX. A 25-strike call may seem deep OTM with VIX at 16, but if the 30-day future is at 22, the option is much closer to ATM than it looks.

VIX-linked ETFs

Several products pool VIX futures into ETFs:

VXX: Long the front two months of VIX futures. Designed to track 30-day forward vol exposure. Bleeds value over time due to contango roll cost.
UVXY: 1.5x leveraged version of VXX. Bleeds even faster.
SVXY: −0.5x inverse of the front two VIX futures. Profits from contango roll. Survived (barely) the 2018 vol spike that destroyed XIV.
VIXY: Similar to VXX, slightly different methodology.

All of these have a structural drift built in. Long-vol products bleed in calm markets. Short-vol products earn in calm markets and can lose enormous amounts in spikes. None of them are buy-and-hold instruments.

Volmageddon (February 2018)

On February 5, 2018, the VIX more than doubled in a single day, going from 17 to 37. XIV, an inverse VIX product similar to SVXY, lost 96% of its value in after-hours trading and was liquidated. Several short-vol funds were wiped out.

The event illustrated two structural realities. First, short-vol positions concentrate left-tail risk in a way that retail investors often do not appreciate. Second, the unwinding of short-vol products itself contributes to vol spikes. As short-vol products are forced to buy back VIX futures to cover their positions, they push the VIX higher, which forces more buying, which compounds. The cascade is real.

How professionals use the VIX

Few professional traders bet on the VIX directly. They use it as a regime indicator, a hedging benchmark, or a building block for relative-value trades. Some examples:

Regime detection. VIX above 25 typically indicates a stress regime. VIX below 15 typically indicates calm.
Term-structure trades. Long the back-month future, short the front, betting on contango persistence (or breakdown).
Cross-asset hedges. VIX calls as a tail hedge against SPX exposure. Expensive but cleanly defined risk.
Relative value. SPX skew vs VIX, VVIX vs VIX, individual-name vs SPX vol. The VIX is a reference point in many such trades.

What you carry forward

VIX measures 30-day SPX implied volatility. It is calculated, not traded directly.
VIX correlates strongly negatively with SPX returns. Falling stocks usually mean rising VIX.
VIX futures usually trade in contango. The roll yield is the basis for many short-vol products.
VIX options reference the corresponding VIX future, not the spot VIX.
Short-vol ETFs concentrate left-tail risk and can blow up in spike events.