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How To Trade The VIX: Understand These Basics

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A ugust saw a huge jump in the VIX index, which measures equity volatility. VIX ETPs are proving popular with investors amid the stock market choppiness.

IBD spoke to Nick Cherney, head of exchange traded products at Janus Capital Group, about how VIX products can be used to trade long and short, to hedge and to manage risk.

Cherney founded VelocityShares in 2009. The company quickly made a mark as a developer of sophisticated solutions for managing volatility for institutional investors and traders. VelocityShares' suite of six VIX products includesVIX Short Term ETN ( VIIX ), which gained 15% in the past month.

In 2014, this upstart firm was acquired by the Janus group, which like other mutual fund giants has sought to make inroads into the flourishing ETF industry by acquiring small, innovative ETF providers.

Cherney, 34, is an avid skier and coach with the Aspen Valley Ski Club who readily admits to suffering at Crossfit.

IBD: What is volatility trading? What does trading VIX futures really mean?

Nick Cherney: Volatility trading is ultimately about people expressing a view on three things: one, how volatile a market will actually be (realized volatility); two, how volatile everyone else thinks that market will be (implied volatility); and three, how much other investors are willing to pay to protect against that market volatility (call that the "fear premium").

The simplest measure of volatility is purely mathematical: it would just be a measure of how large the daily swings in the S&P 500 index were, for example, and this is realized volatility, which all investors are naturally exposed to, but is not directly tradable. By far the most popular measure of equity volatility is the VIX index, which is a measure of people's expectations about the future.

The VIX is based off of option prices, and tells us about the "implied volatility" of the equity market. It also is not directly tradable. The most important instrument people use to actually trade equity volatility is VIX futures (and exchange traded products, or ETPs, linked to VIX futures).

VIX futures returns vary from the returns of the VIX based on the amount people are willing to pay to protect against the implied volatility of the VIX. Most of the time this "fear premium" means that VIX futures are priced much higher than the VIX itself, and are therefore very expensive to own outright.

IBD: What does the huge jump in the VIX in August tell us?

Cherney: Because the VIX is a measure of how much people are generally willing to pay to buy options, it represents the price of protection, which is why it is known as the "fear gauge."

On Aug. 24 the VIX opened above 50, a level it had never reached before (or since) the 2008 financial crisis. This severely elevated VIX level shows that there was a very significant concern in the markets about how serious the equity market turbulence could become.

The volatility event which began in mid-August is certainly the most significant since the fall of 2011, and while the VIX has since moderated and generally stayed below 30 throughout September, this is still far above the levels we have become accustomed to in 2015, generally in the mid teens.

To declare the event over would require the VIX to fall 20% to 30% from those levels down into the mid teens.

IBD: What drove record flows into VIX ETPs last month?

Cherney: Most investors who use VIX ETPs are using them quite tactically, and generally when we see such large moves, that provides more opportunities (and of course risks) for tactical trading strategies. So we generally see that periods of elevated volatility are associated with increased trading volumes in VIX ETPs. In fact the most liquid VIX ETPs now regularly trade as much or more than many blue-chip stocks .

From the end of July through its peak on Aug. 24, the VIX rose over 200% and VIX futures rose over 60%, and those types of moves tend to bring a lot of traders into the market, both initiating new positions and closing out existing positions.

In August, in particular, we saw that most of the money flow in VIX ETPs was actually short VIX futures.

This implies that while the VIX itself was rising as many investors bought protection, there were also a significant number of investors wagering that the VIX would fall back to more normal levels, and they were doing this by either redeeming long volatility products, or investing in short volatility products.

As a result, at the end of August, there was just over $4 billion invested in VIX futures ETPs with about $1.8 billion of that in products that provide short exposure to VIX futures.

IBD: How can VIX ETPs be used -- to trade long and short, to hedge, to manage risk etc.?

Cherney: VIX-related ETPs can be used for all of the above. There are a wide range of VIX-related ETPs on the market, including pure VIX futures-linked products, that can be long, leveraged long, or inverse.

Typically, investors are using long and leveraged long products for extremely short periods of time to try to capitalize on short and abrupt moves upwards in the VIX. Many investors use short volatility products not only to capture quick downward movements in the VIX, but also to capitalize on the "fear premium" in VIX futures; in other words, their tendency to trend downward and significantly underperform the VIX itself.

In addition, there are hedged-equity products available that combine long equity positions with VIX-futures based strategies as part of a more long-term solution to manage equity risk. (Editor's note:Janus Velocity Volatility Hedged Large Cap ( SPXH ) is an example of such a product.)

So rather than have to engage in the daily decision-making and trading process with pure VIX ETPs, investors can gain exposure to VIX futures-based strategies in a vehicle which is designed to be used as part of a long-term asset allocation.

IBD: What are risks and challenges investors need to be aware of?

Cherney: Pure VIX-related ETPs are intended for use by sophisticated and knowledgeable investors who have evaluated and understand their risks, not just their benefits. The prospectus for each product outlines its risks in detail and is the best place for investors to gain a thorough understanding of each product they are considering.

Follow Aparna Narayanan on Twitter @IBD_ANarayanan .

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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