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In the last two articles in this series, we talked about the CBOE Volatility Index (VIX) as one of the most effective technical indicators available to traders.

See Part I of this series on trading the VIX.
See Part II of this series on trading the VIX.

The VIX can help you to understand changes in risk, option premiums and market trends. However, the VIX is also a very interesting instrument for traders to profit from. You can essentially trade changes in the VIX through futures, options or exchange-traded notes (ETNs).

The mechanics of executing a futures, options or ETN trade are not complicated. However, although the order entry and analysis process for executing trades based on VIX instruments is relatively straightforward, there are some very unique characteristics that you need to understand BEFORE you start making trades.

In the video at the end of this article, I will show you why the VIX’s tendency to “revert to the mean” creates these unique features.

Futures

There are futures contracts based on the VIX available for traders with access to a futures trading account. VIX futures are probably not a good idea for novice traders or traders with a small capital base, as each point move in the future’s price is worth a $1,000 gain or loss per contract.

Options

There are index options based on the VIX available to traders with a standard stock and options brokerage account.

You can buy or sell calls and puts, or create spreads, strangles or straddles like you would a traditional options trade.

However, there are a few things to keep in mind when trading VIX options:

• Because the VIX tends to revert back to the mean, at-the-money calls and puts with the same strike price may have very different premiums. For example, if the VIX is very high, it is more likely that it will begin to decline in the near term than rise further, and this will make puts much more expensive than calls. The same is true in reverse.
• VIX calls and puts expire 30 days prior to the next month’s expiration of S&P 500 (SPX) index options. That means that they expire on the Wednesday before or the Wednesday after normal expiration Friday. This is not a problem for most traders, but it can be confusing if you were expecting a Friday expiration.
• Option traders investigating VIX options for the first time may find time spreads (calendar spreads, diagonal spreads, etc.) appealing at first glance. However, this is because each month’s VIX options are based on a different month’s SPX index options expiration date. This distorts these spreads to look much more attractive than they really are. You can dig into the details of why this is and what the risks are, but take our word for it and just don’t do it.

ETNs

Exchange-traded notes (ETNs) trade like stocks, and can be a little easier to manage for new VIX traders than calls and puts. An ETN is very similar to an exchange-traded fund (ETF), and because it trades like a stock, it can easily be added to the active-trading portion of your portfolio.

Keep in mind that because all market participants know that the VIX tends to revert back from extreme highs and lows, the movements of a VIX ETN will be somewhat less dramatic than the actual movements of the index.

Learn the difference between ETFs and ETNs.

Trading the VIX

Trading the VIX is easy to do if you are inclined to add it to your list of investment strategies.

It is easy to analyze and is negatively correlated to a very high degree with stocks, which creates an opportunity to diversify. However, remember that VIX investments have some unique characteristics that make paper trading a must before jumping in and making live trades.

John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.

This article originally appeared on the Learning Markets Web site.