On March 26, investors will be able to trade the VIX future, which will supposedly help them hedge the volatility risk of their portfolios. But the caveat "past performance is no guarantee of future performance" has never been more applicable than it is with this product.

The Chicago Board Options Exchange Volatility Index (VIX) is a leading measure of investor sentiment. VIX futures will trade under the symbol VX, and they will track the level of the Jumbo CBOE Volatility Index (VXB), which is 10 times the value of VIX. The contract size is 100 times the value of VXB. For example, a contract will cost $18,500 if the VIX is 18.5. The last trading day is the Tuesday prior to the third Friday of the month.

Several structural problems make the VIX future an unreliable hedging instrument. The Chicago Board Options Exchange suggests several strategies for using the new product, but examine them carefully before you start trading. CBOE.com suggests trading the new financial instrument for these purposes:

  • To take advantage of a market view on the direction of near-term volatility.

  • To hedge volatility risk.

  • To manage risks associated with the growing markets for volatility and variance swaps.

  • To take advantage of arbitrage opportunities between S&P 500 options and VIX futures and options.

I'll take you through each of these suggested uses and explain just why the VIX future might not be the right trading tool for you. I'll list each one and point out the potential problems.

  • To take advantage of a market view on near-term volatility.

First, there's a time mismatch between the VIX and the future. The VIX represents the market's expectation of 30-day volatility. On the other hand, the future is the market's expectation of next month's 30-day volatility. For example, April futures will settle on the third Wednesday of April. On that date, the VIX will represent the market expectation of May's volatility. So the future cannot be used for any front-month volatility views.

  • To hedge volatility risk.

The future can hedge non-front-month vega exposure, but not gamma risk. Realized volatility does not have a high correlation to forecast implied volatility.

The future will not profit from the actual movement of the index, except to the extent that forecast implied volatility increases. At best, it can protect a trader who is short two-month or longer options from vega risk until the options become front-month. (As an example, that's a long April future vs. short May options.) Vega measures the rate of change in an option's price for a one-unit change in the implied volatility.

Traders will always be exposed to adverse movement in the underlying index (gamma risk). Short gamma positions can never be hedged with this future.

  • To manage risks associated with the growing markets for volatility and variance swaps.

The VIX squared future will be an indication of the variance swap for next month. However, the VIX squared future won't settle for 30 days, so to hedge it accurately, you need to be long VIX squared future vs. short one-month options (or variance swap) and long two-month options (or variance swap). The option portfolio value will vary linearly with the VIX squared.

  • To take advantage of arbitrage opportunities between S&P 500 options and VIX futures.

There is no perfect correlation between S&P 500 options and futures for any arbitrage to exist. The closest relationship is long future vs. short one-month options and long two-month options. This position will have no vega exposure, but it will have a negative gamma. Additionally, as the market moves, you'll need to adjust the option weighting of the portfolio. Transaction costs combined with hedging error make this a difficult arbitrage to obtain.

In Part 2 of this primer, I'll dig a little deeper and find some potential uses for the VIX future.
Paul Haber is a proprietary options trader. At time of publication, Haber held no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to phaber@thestreet.com.