Dont Use VIX ETFs to Bet On Volatility

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The VIX volatility index is a mathematical calculation, not a stock, so it cannot be invested in directly. Rather, traders can invest in the VIX through futures, options, or ETFs. Even the best VIX ETFs aren't a good idea for long-term investors, due to their poor correlation with the VIX and its inherent downward bias.

What is the VIX?

In a nutshell, the VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which is a measurement of the implied volatility of S&P 500 index options. Essentially, a higher VIX means that traders expect a more volatile market over the next 30 days. For this reason, the VIX is commonly referred to as the "fear gauge" or "fear index."

VIX futures have been trading on the CBOE since 2004, and take into account the current market prices for all out-of-the-money call and put options for the front month and second month expirations.

While the actual calculations that go into VIX are quite complex, reading the index is fairly simple. The number represents the expected percentage range of movement of the S&P 500 --either up or down -- over the next year, with a 68% confidence interval (one "standard deviation," in statistics terms). For example, if the VIX is 20, that means: "Based on options data for the next 30 days, traders are 68% confident that the S&P 500 will remain within 20% of its present level over the next year."

Now, that's an annualized number, but as noted above, it's really only measuring for the next month. Without going too deeplyinto the mathematics (other than to say that volatility does not increase linearly over time), here's how to convert that VIX number into a shorter-term expected volatility range.

For the monthly number, divide VIX by the square root of 12 (3.46). For the weekly number, divide by the square root of 52 (7.21). So, to continue with the example above, a VIX of 20 would suggest that the S&P will stay within a range of plus or minus 5.8% (20 divided by 3.46) its current price for the next 30 days.

VIX ETFs -- Not a perfect correlation

There are a few ways investors can trade the VIX. VIX futures contracts and options have been available for over a decade, and are derivative instruments directly tied to the VIX. However, since it's not a stock, nor even a basket of them, but a mathematical calculation, there's no way to invest in it directly.

One alternative is to buy a VIX ETF, and the most popular of those is the iPath S&P 500 VIX Short-Term Futures ETN (NYSEMKT: VXX). Such ETFs invest in VIX futures contracts, but this doesn't produce a perfect correlation to the VIX. In fact, on a 25% spike in the VIX on Aug. 20, 2015, the iPath ETF only gained 8%.

And, because of the structure of futures-based ETFs, the funds must buy more expensive longer-dated contracts while selling cheaper short-dated ones, effectively buying high and selling low. Over time, this creates a downward pressure on the ETF's price. To illustrate this, consider that while the VIX has dropped by 20% since the beginning of 2013, the iPath ETF has plunged by nearly 92%.

VXX data by YCharts

In short, a VIX ETF is not a good long-term investment. It's also important to point out that ETFs that effectively short the VIX (inverse ETFs) or are designed to double the VIX's performance (leveraged ETFs) have the same downward bias over time. To be perfectly clear, VIX ETFs are virtually guaranteed to lose money over the long term.

So why would anyone buy a VIX ETF?

Having said all of that, there are some legitimate uses for VIX ETFs. For example, an investor may buy a VIX ETF to hedge against short-term volatility in the market. The VIX tends to spike when the market drops rapidly, making a volatility-tracking ETF a protective bet against a market crash. Brexit offers a good recent example: An investor could have bought shares of the iPath ETF the day before the U.K. vote to protect against a possible market crash if the results favored "leave." In this case, the S&P 500 lost 3.6% on the following trading day, while the ETF gained 24% on the spike in the volatility, which would have helped investors to offset their losses.

However, this type of strategy is a variation of market timing, and is generally not a good idea for retail investors. In fact, any investment with a downward bias -- VIX ETFs, leveraged ETFs, and any other futures-based ETF product -- is generally not a good idea for investors with a long-term mentality.

The bottom line on VIX ETFs

While instruments like VIX ETFs do indeed serve a purpose in the market, they are best left for professionals and short-term traders. Volatility spikes can certainly cause your stocks to drop in the short term, but as long as you have a well-diversified portfolio of rock-solid companies, simply stay the course and you'll be fine in the long run.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.