Why is there no ETF that directly tracks the VIX index?

As I explained my trading strategy to a friend of mine, he asked, “Why do you trade the VIX Futures? Is there no ETF that directly tracks the VIX index?” Because of that, I realized that many new traders may come across the VIX at some point but don’t understand how to trade it. So, I will briefly cover a few basic points. First is what the VIX index actually is. Secondly, why there is no ETF directly tracking the VIX. Thirdly, what it would mean if everybody could simply buy the VIX or an ETF mirroring the VIX one to one.

In this article, we will explore the possibility of directly trading the VIX and how you can effectively trade volatility and the VIX.

VIX is a Cash Index

The basic definition of the VIX index, more properly known as the CBOE Volatility Index, is as follows: Calculated based on a strip of S&P 500 options, the VIX index measures, within one standard deviation, the forward one-year expected movement of the S&P 500.

The VIX is just a representation of forward expected returns of the S&P 500 based on market activity in the options market.

Other indices like the S&P 500, NASDAQ, or the Russell 2000 are calculated according to the market capitalization of their component companies. Those indices change value because of the movement of the underlying stocks. When the asset-valued average of the underlying assets rises, the index rises.

Since options, unlike stocks, have an expiration date, the VIX has to reflect always new options with an average of 30 days till expiration. Furthermore, the VIX does not measure just the pure value of those options but only one part of their price-forming component, implied volatility. The VIX rises when the implied volatility rises.

Because of that, the VIX index is a so-called “Cash” index. Cash means that the VIX index has no underlying assets or securities that an ETF could directly hold or replicate. The VIX Index is just a synthetic calculation designed to give traders and investors a clear impression of implied volatility.

You may have heard that the VIX is also called the “fear gauge” of Wall Street, and that is a very good analogy. Just like a fever thermometer for humans, the value on it is just a measurement.

The Need for VIX Futures

For a long time, the VIX index was in no way or form tradable. The VIX was introduced in 1993, but only 10 years later, in the year 2004, was it somehow tradable. Goldman Sachs engineered together with the CBOE tradable Futures and Options on the VIX. Since 2004 VIX Futures and since 2006 VIX Options are tradable. Barclays emitted the first volatility-based ETP in 2009, known today as VXX.

The VIX Futures are a freely traded market. There is no clear relationship between the VIX Futures and the VIX, with one exception.

At the expiration, the first VIX Future has to be equal to the VIX Index. It can be observed that the VIX Futures converge to the VIX Index price as the expiration day approaches.

To continue the comparison to a fever thermometer: It is not possible to speculate on the value on the thermometer itself, but you can speculate whether or not the value of the thermometer will exceed or dip below 100 degrees in a given month or year.

VIX ETF = Free Lunch

An ETF that would directly track the VIX Index would be a free lunch. And in the world of trading and investing, there is no such thing as a free lunch. To understand what I mean by that, I want to answer the question: What would it mean if there was such an ETF directly tracking the VIX index?

In short: The markets as we know them would not be able to function anymore if there were such a thing as a directly tradeable VIX. The VIX is mean-reverting, which means after a big spike, it will come down, and after some time at low levels, the VIX will spike up.

So every trader and investor would buy this ETF if the VIX were below its average, around 15, and would sell it short every time the VIX were above it. This way they would be able to lock in free profit, which of course cannot be. There is no such thing as a free lunch.

In addition, it would be possible to hedge a portfolio for basically free since there would not be any hedging cost involved in just holding a directly tracking VIX ETF.

Why not do the same with VIX Futures? With VIX Futures or with the volatility ETPs like VXX, UVXY, and SVXY, this isn’t possible because of the expiring nature of the VIX Futures. Trading the VIX Futures, you are not only betting on the direction of the VIX but also on the timeframe this move has to happen.

If the VIX Future expires before the move in the VIX happens, you just lose money. This effect is called roll yield and affects all futures, just like oil, natural gas, or even index futures like the S&P 500 Futures.

To end the comparison to a thermometer: If it would be possible to trade the value of the thermometer without a limitation of time, everybody would buy that value if it sinks below 100 degrees, after you went for a swim in an ice-cold lake, for example. On the contrary, someone would sell the value of the thermometer short every time you catch a cold and develop a fever.

The expiration of the VIX Futures forces all investors to speculate not only on the direction (hot/high or cold/low) but also on the time to recovery or reversion to the mean.

Conclusion

In conclusion, the absence of an ETF directly tracking the VIX index stems from the VIX’s unique status as a cash index. Unlike traditional indices based on underlying securities, the VIX is a synthetic calculation without assets for ETF replication.

Creating a VIX ETF would introduce the possibility of exploiting a risk-free scenario akin to a “free lunch.” Given the VIX’s tendency to revert to its mean, traders might buy the ETF when the VIX is below its historical average and short it when it’s above, potentially disrupting market stability. This concept challenges the core trading principle that there are no effortless profits in financial markets.

In contrast, VIX Futures have expiration dates, preventing straightforward arbitrage and aligning with established risk-reward principles, making them preferred instruments for trading VIX-related movements.