Two New Ways to Play Volatility, With Caution

This column was originally published on RealMoney on June 11 at 3:01 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

It should come as no surprise that following last week's selloff, there's a new round of predictions that we are heading into a period of higher volatility. This comes at the perfect time for the Chicago Board Option Exchange (CBOE), home of the well-known VIX or fear index, which is based on the implied volatility of the S&P 500 option.

The CBOE is launching two new volatility index futures contracts: one on the CBOE Nasdaq 100 Volatility Index (VXN), with a futures symbol VN; and one on the CBOE Russell 2000 Volatility Index (RVX), whose futures symbol will be VR. Both will begin trading on July 6. So if you are expecting some post-July 4 market volatility fireworks, you have more weapons in your arsenal.

Of course, as I've stated on numerous occasions, trading futures on volatility is tricky. Indices tend to revert to the mean, meaning the futures tend to have a dampening effect; a spike in the cash index will not be fully reflected in the price of the futures contract.

Previous predictions that we were "entering a period of increased volatility" have proven short-lived. The most recent was the selloff in early March, which sent the VIX above 20, but it was back below 15 with three weeks. Last week we saw the VIX spike to 17.50. It's already back down to 14.20 this session. November futures moved from 15 to 16 and are now back to 15.

The VIX futures and the options on those futures have enjoyed impressive growth in volume since they were launched more than a year ago. But most individual or retail investors have been frustrated in finding a way to successfully use them as either speculative instruments or tools for portfolio protection because the correlation between market declines and the increase in implied volatility is a moving target. Variables such as the rate of the decline are important elements.

Typically only the front month or near-term contract will reflect current market conditions, meaning one would do just as well buying options through a straddle or other long gamma positions on the underlying index option.

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