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What Is a Volatility ETF, and How Does It Work?

Eric Reed
·5 min read
Man and woman balancing on the line of a graph
Man and woman balancing on the line of a graph

A volatility ETF is an exchange traded fund (ETF) that tracks share price changes in a specific index of the stock market. These funds make their money based on the degree to which prices are changing across the market. The specifics are different based on individual funds, as various volatility ETFs offer exposure to volatility in varied ways. However, if you want to trade based on how turbulent you think the market will be, these are often worth considering. Here’s what you need to know to make an investment decision about these securities. Of course, it’s always a wise idea to consult with a financial advisor when considering an investment, including an ETF investment.

Understanding Volatility

Volatility is the measurement of how much an asset’s price moves or how much an index moves. Large changes are associated with higher volatility, while relatively smaller changes are associated with stable prices. This holds true in either direction. An asset or index is considered volatile if it makes either large gains or losses in a short period of time. For example, a stock that gains $10 in one day would be considered far more volatile than a stock that lost $10 over the course of 10 trading days.

Traders generally associate volatility with uncertainty in the market. They consider slow, steady gains the prime markers of confidence in a market’s value, while big leaps in any direction show more guesswork at play. That said, volatility tends to correlate with market declines. A highly volatile market is often one in which assets are losing value.

Volatility can apply on any scale, from individual stocks up to an entire market. Measuring the volatility of an entire market is generally a critical task for traders, who want to understand how and where to move their money.

To measure and communicate near-term volatility, the Chicago Board Options Exchange (CBOE) created the Volatility Index, or the VIX. This index, also known as the Fear Index, is the most followed index, and it measures volatility based on prices across the S&P 500. As the stock market gets more turbulent the VIX index rises. Like any analytical tool, the VIX is subject to flaws, since no model can predict the future with complete accuracy. However, given that it is based on existing price and trading data, the VIX model has been largely accurate at reflecting market volatility. The VIX is not the only volatility index, but it is the most commonly used index for American markets.

What Is a Volatility ETF?

Muslim investors sell ETF shares
Muslim investors sell ETF shares

Volatility ETFs are exchange traded funds that track an index of market volatility. While investors have built many products around volatility, and the VIX particularly, these can be good opportunities for investors who would like to trade on market fluctuations while preserving the liquidity that equity-like ETFs have to offer. In many ways these products mimic other index funds. Like an S&P 500 or Dow Jones Industrial Average index fund, for example, a VIX ETF gains and loses value based on the activity of the VIX itself. Firms typically build this product using futures and options contracts, rather than trying to build a portfolio out of VIX-related stocks.

The CBOE directly sells contracts based on the VIX itself. These, in turn, comprise a base of financial products whose value can be used to build a derivative index fund that itself tracks the value of the VIX. It’s important to note, however, that this makes it difficult for volatility ETFs to closely track their index. These funds often miss their mark, with many doing no better than a 50% relationship with their target index.

As you explore volatility ETFs you will note that many are technically considered exchange traded notes or ETNs. These are debt instrument with similarities to to an ETF. However, unlike an ETF these funds do not hold any assets. Rather an ETN is an unsecured debt obligation backed only by the promise of the borrower to pay its investors based on the performance of a particular index. From the perspective of a retail investor, however, the experience of investing in an ETF or ETN is virtually the same.

When trading a volatility ETF, first determine the position you would like to take.

  • Standard – In a standard fund, your returns will increase as the VIX does. Higher turbulence will cause these funds to gain value, so invest here if you expect market instability or potential decline.

  • Inverse – An inverse volatility ETF shorts the VIX. This fund gains value as the VIX goes down. Purchase this fund if you expect overall stability or steady growth.

Given their nature, investing in a volatility ETF (or ETN) has the same ease as trading equities. These products are bought and sold in the public market. One popular example of a volatility ETF is the iPath Series B S&P 500 VIX Short-Term Futures ETN, traded under the symbol VXX. At time of writing this was the largest volatility index fund, with nearly five times the listed assets as the next largest fund.

The Bottom Line

Stock index graph on a chalkboard.
Stock index graph on a chalkboard.

A volatility ETF is a fund that tracks the VIX or some other specific stock market index. These funds allow you to trade based on how much stability or chaos you expect in the components of a particular stock market index. A volatility ETF differs from a volatility ETN only in the fund’s structure. The former holds securities that can be sold by the investor; the latter is a debt instrument that holds no securities but pays investors based on the performance of an index.

Tips for Investing

  • Consider talking with a financial advisor if you’re not sure how to respond to market volatility or the lack thereof. Finding a financial advisor doesn’t have to be hard. With SmartAsset’s matching tool you can find several in your area who can help you get sound, calm advice that will ensure that your trades are made based on long-term planning, not short-term turbulence. If you’re ready, get started now.

  • While there are similarities between index funds and ETFs based on the same index, there are key differences. Be sure you understand the differences between the two before you make an investment in either type of security.

Photo credit: ©iStock.com/DNY59, ©iStock.com/airdone, ©iStock.com/marrio31

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