'Fear Index' is Back

After spending most of the year in hibernation, the CBOE Volatility Index (^VIX) is back. The gauge has soared more than 25% over the past seven trading sessions and could be a fore gleam of what lies ahead in 2013.

The CBOE Volatility Index or "VIX" is a widely used yardstick of (NYSEARCA:IVV) so-called "fear" because it tracks the expected volatility of the S&P 500 over the next 30 days. The measure is calculated from option prices.

While it's still too early to determine whether rising volatility will morph into a longer-term trend, the short-term trend is up. And like a sleeping giant, the VIX is starting to move.

In the January 2013 edition of the ETF Profit Strategy Newsletter (published on 12/17) we wrote:

"Both the CBEO Put/Call ratio and the VIX are drenched with complacency. Going long the VIX in 2012 for any extended period has resulted in outsized losses, but playing the short term bounces has been profitable. The VIX has refused to spend much time below the 15 level providing a solid support and buying area for VIX bulls. As it approaches that level, buying front month in the money calls is a good trade. Almost every time the VIX has moved below the 15 level, at a minimum a short term top in the S&P occurred and the VIX eventually rallied to 19. Previous 10% declines have sent the VIX into the upper 20s. We like going long the VIX JAN 14 CALL options (VIX130116C00014000) at $271 per contract." (After peaking near $650, the JAN 14 VIX Calls closed on 12/27 at $540 per contract)

We also explained to readers that our preferred method for trading the VIX is using call/put options instead of VIX ETPs. The chart below shows why.

You'll note a 5.5% performance drag for the ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY) compared to the VIX itself over the past seven trading sessions. The chart proves that for even shorter periods, getting precise exposure to the VIX with ETFs or ETNs is next to impossible.

The prospectus for VIXY admits this much:

"Each VIX Fund is benchmarked to its respective VIX Futures Index and the VIX Funds are not linked to the VIX, to realized volatility of the S&P 500, or to the options that underlie the VIX calculation. Each VIX Fund should be expected to perform very differently from the VIX over all periods of time. In many cases the VIX Futures Indexes will significantly underperform the VIX. Furthermore, because each VIX Fund may invest in VIX futures contracts other than the VIX futures contracts comprising the Fund's VIX Futures Index, the VIX Funds may perform differently than their respective VIX Futures Indexes."

Sincethe VIX is not a directly investable thing, VIX ETFs and ETNs get their exposure to S&P 500 volatility using VIX futures contracts. Each of the VIX futures indexes these ETPs use measure movements of a combinationof VIX futures and is designed to track changes in the expectation for VIX over a specific time window in the future. As a result, the S&P 500 VIX Short-Term Futures Index and VIXY can be expected to perform differently than the VIX itself.

Other VIX linked ETPs like the iPath S&P 500 VIX ST Futures ETN (NYSEARCA:VXX) and the VelocityShares Long VIX ST ETN (NYSEARCA:VIIX) operate in a similar fashion.

Even if you have no plan to trade volatility, a hedged VIX position can be used to protect your stock market (NYSEARCA:DIA) gains. The ETF Profit Strategy Newsletter continuously monitors the VIX along with other market indicators and makes recommendations on how to capitalize.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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