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).