Investing in Volatility: From the VIX to Volatility Strategies

Volatility is often described as the market's "fear gauge" — a measure of uncertainty about future equity returns that spikes during crises and falls during calm periods. For most investors, volatility is simply a background condition to be endured. For a specialist subset, volatility itself is a tradeable asset: a source of risk premium, a tool for tail-risk hedging, and a means of expressing views on market uncertainty that are distinct from directional views on equity direction. This guide explores how volatility is measured, traded, and invested in — and why the risks in this space are among the most severe in financial markets.

The VIX: Definition and Calculation

The CBOE Volatility Index (VIX) is the most widely known measure of implied equity market volatility. Published by the Chicago Board Options Exchange (CBOE), the VIX measures the market's expectation of 30-day forward volatility for the S&P 500, derived from the prices of a wide range of S&P 500 options at various strikes.

The VIX is expressed in annualised percentage terms. A VIX of 15 implies the market expects the S&P 500 to move approximately ±4.3% over the next month (15% ÷ √12). A VIX of 30 implies an expected monthly move of approximately ±8.7%.

The VIX is not directly investable. An investor cannot "buy the VIX" in the way they can buy a share. The VIX is a calculated index, not a security. Exposure to the VIX is obtained through:

• VIX futures contracts (traded on CBOE).
• VIX options (options on VIX futures).
• Exchange-traded products that hold VIX futures (ETPs) — see below.

The VIX Futures Curve and Contango

VIX futures do not price at the same level as the spot VIX. Instead, they form a term structure (or futures curve) that reflects the market's expectation of where volatility will be at future dates.

In most market conditions — when markets are calm — the VIX futures curve is in contango: near-month futures trade below far-month futures (or, alternatively, the spot VIX is lower than nearby futures). This is because volatility tends to mean-revert: if the spot VIX is low today, the market expects it to be somewhat higher at future dates.

Contango has devastating implications for investors who hold long VIX futures positions over time. As a front-month futures contract approaches expiry, it converges towards the (lower) spot VIX. The investor who "rolls" the position — selling the expiring contract and buying the next month — continuously buys high and sells low. This roll cost is the primary reason that holding long VIX products over extended periods is an extraordinarily poor investment in normal market conditions.

In contrast, selling VIX futures (being short volatility) captures the roll yield — continuously selling high and buying low. This short volatility carry trade has historically generated positive returns in calm markets, earning the roll premium, but is subject to catastrophic losses when the VIX spikes.

The XIV Implosion: A Cautionary Study

No discussion of volatility investing is complete without examining the catastrophic collapse of the VelocityShares Daily Inverse VIX Short-Term ETN (ticker: XIV) in February 2018.

XIV was designed to deliver the inverse of short-term VIX futures returns — effectively, a packaged short volatility position that profited when volatility was low or falling. From 2012 to 2017, XIV returned over 500% as implied volatility remained subdued. It attracted significant retail and semi-institutional investment on the basis of this extraordinary trailing return.

On 5 February 2018, the VIX spiked from approximately 17 to above 37 intraday — a rise of more than 100% in a single session — as equity markets sold off sharply. The structure of the XIV product required it to buy VIX futures as volatility rose to rebalance its inverse exposure. This mechanical buying accelerated the VIX spike further. By the close:

• XIV had fallen approximately 96% in a single day.
• The product was subsequently delisted, with investors recovering only a small fraction of their capital.

The XIV episode illustrates the reflexivity risk of short volatility products: in a volatility spike, their mechanics can amplify the very event they are betting against. Products with inverse or leveraged volatility exposure are deeply inappropriate for investors who do not fully understand the path-dependency risks of daily-rebalancing structures.

Long Volatility Strategies

The opposite of short volatility — long volatility — involves positions that gain when implied volatility rises. Long volatility strategies are typically loss-generating in calm markets (paying for protection through option decay) but can deliver exceptional returns during equity crises.

Buying VIX calls: Purchasing call options on VIX futures gives the buyer a direct payoff if the VIX rises above the strike. A portfolio manager might buy VIX calls as explicit tail hedges — accepting regular premium costs in exchange for a large payoff during a market crisis when equity losses are occurring.

Variance swaps: Institutional instruments that pay the difference between realised variance (actual squared daily returns) and implied variance (the variance implied by option prices at the swap's inception). If actual volatility exceeds expected volatility, the variance buyer profits. Variance swaps are OTC derivatives, accessible only to institutional investors, and are a purer expression of volatility views than options on the VIX.

Option volatility positions (straddles, strangles): Buying both a call and put simultaneously creates a position that profits from a large move in either direction (a straddle if at the same strike; a strangle if at different strikes). These are long volatility, positive vega positions that generate profits if implied volatility rises or if realised volatility significantly exceeds what was implied at purchase.

The Volatility Surface and Skew

The VIX is an average of implied volatility across many strikes and expiries. More information is contained in the volatility surface — a three-dimensional mapping of implied volatility as a function of strike price and expiry date.

Volatility skew refers to the pattern by which out-of-the-money puts (downside protection) command higher implied volatility than out-of-the-money calls. This skew is a persistent feature of equity markets — driven by investor demand for crash protection — and creates opportunities for sophisticated strategies:

• Skew trades: Selling expensive OTM puts and buying cheap OTM calls (or vice versa) to profit from skew mispricings.
• Term structure trades: Trading the spread between short-dated and long-dated implied volatility.

CBOE Strategy Benchmarks

The CBOE publishes several benchmark indices that track specific options-based strategies:

BXM (Buy-Write Index): Tracks the performance of the S&P 500 with a systematic covered call programme (selling the nearest monthly ATM call against the index). The BXM has historically produced similar risk-adjusted returns to the S&P 500 with lower standard deviation — but underperforms in strongly trending bull markets.

PUT Index: Tracks the return from systematically selling cash-secured S&P 500 put options (the short volatility premium strategy). The PUT Index has historically outperformed the BXM modestly, reflecting the additional premium available from put skew.

These indices provide benchmarks for evaluating managed volatility fund performance.

UK-Accessible Volatility Products

Short-term VIX ETP products (ProShares SVXY, etc.) are US-listed and generally accessible through international brokerage platforms. Given the risks described above, these are appropriate only for investors with a deep understanding of VIX futures dynamics.

UCITS long volatility funds: Some UCITS-compliant liquid alternatives funds take explicit long volatility positions as tail risk protection. These funds are typically offered alongside other risk strategies. Selection is limited but growing; investors should examine the fund's specific approach to long volatility (VIX options, variance swaps, option-buying programmes, or systematic delta hedging).

Options on FTSE 100 (ICE Futures Europe): UK investors seeking volatility exposure through domestic markets can use FTSE 100 index options, accessing implied volatility through direct option positions or volatility spread strategies. Liquidity is thinner than US markets.

Volatility products involve extreme risks including the potential for near-total loss of capital in short periods. Short volatility positions are subject to catastrophic loss during volatility spikes. Long volatility positions incur ongoing decay costs. This guide is for informational purposes only and does not constitute financial advice. Derivatives are not suitable for all investors; ensure you fully understand the risks before investing. Seek qualified professional advice.

How Global Investments Can Help

Global Investments works with sophisticated investors who seek to incorporate volatility strategies within their portfolios — whether as tail-risk hedging, premium harvesting, or as a distinct diversifying return source. Our investment team can assess the volatility exposure implicit in your current portfolio, identify appropriate long volatility hedging approaches, and connect you with specialist managers running institutional-quality volatility strategies. Contact us to discuss how volatility can be used thoughtfully within your overall investment framework.