The one constant on the stock markets is change. Said differently, volatility is a constant companion to investors. Ever since the VIX Index was introduced, with futures and options following later, investors have had the option to trade this measurement of investor sentiment regarding future volatility. At the same time, realizing the generally negative correlation between volatility and stock market performance, many investors have looked to use volatility instruments to hedge their portfolios. (For related reading, check out Getting A VIX on Market Direction.)
Unfortunately, it is not quite that simple and while investors have more alternatives than ever before, there are a lot of drawbacks to the entire class.
A Flawed Starting Point?
One significant factor in assessing exchange-traded funds (ETFs) and exchange-traded notes (ETNs) tied to VIX is VIX itself. VIX is the ticker symbol that refers to the Chicago Board Options Exchange Market Volatility Index. While often presented as an indicator of stock market volatility (and sometimes called the "Fear Index") that is not entirely accurate.
VIX is a weighted mix of the prices for a blend of S&P 500 index options, from which implied volatility is derived. In plain(er) English, VIX really measures how much people are willing pay to buy or sell the S&P 500, with the more they are willing pay suggesting more uncertainty. This is not the Black Scholes model, in other words, and it really needs to be emphasized that the VIX is all about "implied" volatility.
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