Can VIX-ETFs be used as a hedge against a market crash?

After the stock markets experienced a dramatic crash during the Corona crisis, many investors are wondering whether one can profit from a crashing the stock market by investing in the VIX ETF (e.g. ISIN: LU0832435464, WKN: LYX0PM), or whether such ETFs can be used to hedge existing long-term equity investments. In order to evaluate this, first one needs to understand how the VIX Index is calculated.

Calculation of the VIX index:
The basis is a basket of real, observed stock option prices, from which the implied volatility is calculated as a weighted average. Stock option prices (measured by volatility) rise 75% -80% of the time when the general stock market falls. When share prices rise, volatility tends to decrease. This inverse relationship between share prices and volatility is caused less by the mathematical option price model than by the real market of option buyers and option sellers. Since most players in the stock market are “long” in stocks, the need for hedging (i.e. many players want to buy put options) increases sharply when prices fall – and option sellers can get higher premiums (measured and then calculated as implied volatility) for the options offered. As soon as a countermovement sets in in the stock market, the demand for options and with it the option premiums usually fall – and consequently the volatility measured in the VIX index.

Since the VIX index is a derivative, investors cannot invest directly in the VIX index. However, futures contracts on the VIX are actively traded between buyers and sellers. Accordingly, the VIX ETFs offered can only invest in VIX futures and thus do not replicate the VIX index, but a value that results from the constant rolling of one “front-month” future into the next “front-month”. The VIX-ETF buys e.g. always the next due VIX futures contract, holds it until shortly before the due date, then sells it and engages in the next “front-month” future. Accordingly, there is a considerable difference in the price of the VIX-ETF and the VIX-Index, which is quoted in the financial newspapers.


Long-term comparison of the VIX Index and VIX ETF:




Lyxor VIX-ETF:   



The chart comparison of ETF and VIX index clearly shows that investing in a VIX ETF can lead to losses in the long term even if the price of the VIX index moves sideways or even rises slightly. This can then be due to the unfavorable “roll costs”, since the underlying of the VIX ETF is the VIX future. E.g. the VIX future delivery in one month is trading at 12%, that for delivery in two months is trading at 14%. The ETF is usually invested in the so-called “front month” future and “rolls” into the next future on a specific date (i.e. it sells the old month and buys the new month). If the current VIX index (cash basis or spot basis) is very low (e.g. at 10%), the expectation of market participants is often a “reversion to the mean”, i.e. then the VIX future for delivery in 3 months could stand at 15%. After e.g. 3 months have passed and if the volatility has not increased, this future would then also be trading at 10% again. This results in losses in the futures prices, although the cash index, which is quoted in the newspapers, is going sideways. The ETF reflects this unfavorable movement through its constant rolling into the “front-month” future. *

Therefore, it is not enough for investors to buy the VIX-ETF when the VIX index is low and wait for a crash in the stock market to occur – in the expectation that the VIX-ETF will follow this movement without any roll-over costs. In order to make money from a stock crash with the VIX-ETF (or to use it as a hedging instrument), the timing has to be reasonably right. Depending on the structure and ratio of the VIX futures prices, the slump in the stock market that is speculated on should be foreseen for at least a few quarters in order to be able to profit with the VIX ETF. As with most ETFs that have commodity futures as an underlying, a long-term, pure “buy and hold” does not work here, because of the rollover losses.

* the opposite case is also conceivable – that the VIX Cash Index e.g. is at 70%, but the futures are already pricing in a significantly lower volatility, e.g. delivery in 3 months would be 35%. Should the VIX index then remain relatively high, then so-called “roll profits” would arise in the VIX ETF. You can see this in the chart comparison during the period of the Corona crash: the VIX index fell much more sharply than the VIX ETF.