The CBOE Volatility Index, otherwise known as the "VIX," is a popular indicator for investor sentiment on the stock market. It's a key barometer of investor fear and confidence and also a popular trading tool for options and equity traders, one widely used as a measure of market risk.

In the last couple of years, exchange-traded products have emerged allowing investors to profit from this volatility index, and thus offer a short-term hedge for stock portfolios.

The VIX was first introduced in 1993, and in March 2004, futures on the volatility benchmark began trading on the CBOE Futures Exchange. In January 2009, the first VIX-related ETF product began trading. Volatility-linked ETFs track VIX futures, rather than the spot price.

Essentially, the VIX helps illuminate how volatile investors believe the markets will be over the next 30 days, by measuring expected or implied volatility on large-capitalization U.S. stocks through the prism of options traded on the S&P 500 index. The VIX is based on the prices of a weighted blend of call and put options. As option premiums rise, the expectations about future volatility in the underlying S&P 500 index rise.

Generally, a high VIX reflects the spiking investor fear in the markets, and a low VIX shows investor complacency in a calm market. Historical data reveals that bull markets have generally corresponded with long-term lows in the VIX, usually under 20. It recently rose above 40. Probably not surprising given all the market volatility.

Understanding The VIX
Since the inception of the index, the VIX has quickly spiked upward during each market downturn, providing investors with a signal that the market bottom was nearing. The VIX tends to "revert to the mean" as gravity kicks in and markets become too oversold.

But investors should keep in mind that the VIX tends to show a negative correlation to the overall performance of the U.S. equities markets. That means people may use this contrarian investment tool to estimate market tops or bottoms on a short-term basis. High market volatility does not necessarily mean a market is bottoming out; however, it does signal extreme duress in the markets.

Making The VIX Work For You
Standard & Poor's has created two benchmark futures indices based on the VIX: the S&P 500 VIX Short-Term Futures Index Total Return and the S&P 500 VIX Mid-Term Futures Index Total Return. The short-term version maintains a constant one-month weighted average maturity by giving investors exposure to daily rolling long positions on first- and second-month VIX futures. The midterm index maintains a weighted average maturity of five months by offering exposure to daily rolling long positions on the fourth, fifth, sixth and seventh month VIX futures.

With the advent of futures-based exchange-traded funds and exchange-traded notes, the average retail investor is now able to gain access to VIX options. These exchange-traded products allow investors an innovative and efficient way to grab exposure in hard-to-reach niche markets.

The VIX as a trading tool offers opportunities in short-term hedging, speculation and even portfolio diversification. But they are not designed as buy-and-hold vehicles.

The first VIX products were ETNs that gave short-term traders exposure so they could hedge equity positions or speculate on spikes in stocks. The ETNs don't actually track the VIX index itself; they follow a basket of rolling volatility futures. As a result, there may be a noticeable disparity between futures-based VIX ETPs and the spot price of the VIX.

The number of VIX products has exploded in recent years. The two ETF options track medium term and short-term VIX futures: the ProShares VIX Short-Term Futures (VIXY) and the ProShares VIX Mid-Term Futures (VIXM).

There are also a number of ETNs investors can use to gain exposure to the VIX. These notes try to reflect the market views on short- or medium-term futures contracts on the VIX. But an investor looking into ETNs should be aware that these notes are senior, unsubordinated, unsecured debt obligations subject to the credit risk of the issuer.

VelocityShares Daily Long VIX
Short-Term ETN (VIIX)
VelocityShares Daily Long VIX Medium-Term ETN (VIIZ)
iPath S&P 500 VIX Short-Term
Futures ETN (VXX)
iPath S&P 500 VIX Mid-Term
Futures ETN (VXZ)

Inverse VIX ETN options include:

VelocityShares Daily Inverse
VIX Short-Term ETN (XIV)
VelocityShares Daily Inverse
VIX Medium-Term ETN (ZIV)
iPath Inverse January 2021 S&P 500 VIX Short-Term Futures ETN (IVO)
iPath Inverse S&P 500 VIX
Short-Term Futures ETN (XXV)

The UBS E-TRACS Daily Long-Short VIX ETN (XVIX) provides an alternative strategy that measures the return of the index by taking a 100% long position in the midterm index and a 50% short, or inverse, position in the short-term index.

Additionally, investors may play on the added exposure in leveraged ETN options through leveraged strategies:

VelocityShares Daily 2X VIX
Short-Term ETN (TVIX)
VelocityShares Daily 2X VIX
Medium-Term ETN (TVIZ)

Potential investors considering leveraged funds should also note that they are not considered long-term holdings. The leveraged funds, along with the rest of the VIX ETPs, aim to reflect the daily performance of the VIX and the funds will rebalance daily. Because of compounding effects, the funds may greatly diverge from the price movements of the underlying index.

Given the nature of the markets, the VIX will oscillate between extreme highs or lows during times of market volatility or complacency.

VIX Futures
Holding the ETPs for the long term may result in performance differences relative to the spot price. The S&P VIX-related benchmark indices hold rolling long positions in futures contracts. Because traders make bets on the likelihood of greater or lower volatility in the future, the prices on futures contracts for longer-dated maturities will reflect the disparate views on futures prices different from current prices. Consequently, if futures contracts cost more than what a near-month contract may be sold for, the trader would take a hit from rolling to the costlier contract. In this situation, the futures market is said to be in a state of contango. On the other hand, if traders anticipate lower volatility in the future, long-term futures contracts will have lower prices compared to short-term futures contracts. In that case, a trader would be able to roll the near-term contract that is about to mature at a profit on the longer-dated contract. This is more commonly known as backwardation.

During times of low volatility, the VIX usually trades in a state of contango because the future is unknown and fraught with potential volatility, whereas the VIX should trade in backwardation if the markets are currently experiencing high volatility, since high levels of volatility will not last forever. For that reason, VIX-related funds tend to be much more profitable during times of high market volatility.

While the VIX exchange-traded products offer a strategic investment tool, investors should be aware of the innate risks specific to these products. As the markets experience bouts of volatility, volatility-based funds could provide a convenient way for the sophisticated investor to stay in the game.

Tom Lydon is editor and publisher of ETF Trends, a Web site with daily news and commentary about the fast-changing trends in the exchange-traded fund (ETF) industry. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net-worth individuals. Disclosure: At the time of publishing, Mr. Lydon's clients owned IndexIQ Agribusiness Small Cap ETF (NYSEArca: CROP).