How Volatility ETFs Can Hedge Your Portfolio During Market Downturns

5 June 2025

Let’s be real. The stock market isn’t a smooth ride—it’s a roller coaster. One day you’re up, feeling like a genius investor sipping piña coladas. The next? Bam! Your portfolio’s bleeding red, and your heart is racing faster than a caffeinated squirrel. That’s where volatility ETFs come into play. They’re like the seatbelts for your investment roller coaster. So buckle in, because I’m going to break down how volatility ETFs can help safeguard your hard-earned money when the market turns into a circus.

What Are Volatility ETFs, Anyway?

Alright, let’s not get too geeky, but we do need some basics out of the way.

Volatility ETFs are exchange-traded funds that track the volatility of the stock market. More specifically, they often follow the VIX—short for the CBOE Volatility Index. The VIX is often dubbed the “fear gauge” of Wall Street because it spikes when investors panic.

Now, most volatility ETFs don’t track the VIX directly. Instead, they track futures contracts tied to the VIX. Sounds complex? Think of it this way: if the VIX were an actual thermometer measuring investor anxiety, these ETFs are tracking the forecast of future temperatures. They’re betting on future fear levels.

Why Should You Care About Hedging?

Let’s say you’re mostly invested in a classic 60/40 stocks to bonds portfolio. That’s fine in normal times. But when everything starts going south—like during a recession or a black swan event—that portfolio can still get hit hard.

Hedging is your insurance policy. Just like you wouldn’t drive without car insurance, you shouldn't invest without some sort of protection. Volatility ETFs can act like an airbag for your investment portfolio. When markets nosedive, these ETFs usually rise, offsetting some of your losses.

The Fear Factor: How Volatility Works Against Market Movement

Here’s where it gets spicy.

Volatility and the stock market have an inverse relationship. When stocks fall, volatility usually jumps. It's like a see-saw—when one side goes down, the other goes up.

So when panic creeps in, and the market tanks, volatility ETFs tend to surge. That’s why smart investors use them like a hedge—while most of their portfolio might be in a downward spiral, the volatility ETF is doing a little happy dance.

Types of Volatility ETFs You Should Know

Not all Volatility ETFs are created equal. So don’t go buying the first one you see on your brokerage app. Let’s break them down:

1. Long Volatility ETFs

These go long on VIX futures. In simpler terms, they benefit when volatility spikes. Examples include:
- ProShares VIX Short-Term Futures ETF (VIXY)
- iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX)

Great for short-term hedging, but they’re not meant for long-term holding. Why? Because of contango (we’ll dive into that soon).

2. Inverse Volatility ETFs

These do the exact opposite—they bet on volatility going down. You’d use these when you think the market will stay calm. For example:
- ProShares Short VIX Short-Term Futures ETF (SVXY)

But warning: These are risky and can burn you faster than touching a hot stove.

3. Leveraged Volatility ETFs

Feel like gambling? These are for you. They offer 2x or 3x exposure. So if the VIX rises 10%, these could jump 20–30%. Of course, the losses go both ways. High risk, high adrenaline.

The Hidden Danger: Understanding Contango

If you’re thinking about holding a volatility ETF for the long haul, let me stop you right there. There’s a sneaky little financial term called “contango” that can eat your lunch.

Contango happens when the future price of a commodity (like volatility contracts) is higher than the current price. Volatility ETFs that roll over futures contracts every month usually buy more expensive contracts and sell cheaper ones.

Translation? They lose a little value with each rollover. It’s like slowly leaking air out of a tire. So while VIX might stay flat, your ETF might still dip over time. That's why these are better suited for short-term tactical moves, not long-haul investing.

Real-World Example: 2020 Market Crash

Remember 2020? COVID hit, markets went bonkers, and fear swept through Wall Street like wildfire.

During that chaotic period, the S&P 500 tumbled fast. But guess what soared? Yup—volatility ETFs.

Take VXX for example. It doubled within weeks as panic set in. That jump helped a lot of investors offset the losses in their portfolios. If you had a small slice of your pie in volatility ETFs, you were hurting less than your neighbor who went all-in on tech stocks.

How to Strategically Use Volatility ETFs as a Hedge

You don’t need to throw half your portfolio into a volatility ETF. In fact, please don’t.

Here’s a smarter way to approach it:

✅ Keep It Small

Allocate 1–5% of your portfolio into a volatility ETF. It’s like adding hot sauce—not the main dish, just enough to give it a kick when needed.

✅ Use It When Risk Rises

Got a bad feeling about the market? Economic data looking sketchy? Use volatility ETFs as a short-term hedge.

✅ Pair It with Market Exposure

If you’re long on the S&P 500, a little exposure to VXX could help soften the blow if things go south.

✅ Set Exit Rules

Don’t hold “just in case.” Set clear rules for when you'll sell. Volatility moves fast. Don’t sleep on it.

Pros and Cons of Volatility ETFs

Let’s keep it real. Everything has its ups and downs.

👍 Pros:

- Great for hedging during sudden market drops
- Liquid – easy to buy and sell
- Accessible – you can trade them like stocks
- Non-correlated asset – typically moves opposite to stocks

👎 Cons:

- Not suited for long-term holding
- Complex pricing due to futures
- Subject to decay (thanks, contango)
- Volatile themselves – they’re not for the faint-hearted

Volatility ETFs vs Traditional Hedging Methods

You might be thinking—“Why not just buy bonds or go to cash?”

Great question.

Here's a quick comparison:

| Hedge Type | Speed of Response | Potential Return | Complexity | Cost |
|----------------------|-------------------|------------------|-------------|------|
| Volatility ETFs | Fast | High | Moderate | Moderate |
| Bonds | Slow | Low | Simple | Low |
| Gold/Silver | Medium | Medium | Simple | Low |
| Options (Puts) | Fast | High | High | High |
| Cash | Immediate | 0% | Simple | None |

So, volatility ETFs strike a balance. They’re quicker and more reactive than bonds, but not as intense as managing options contracts.

Who Should Use Volatility ETFs?

Not everyone should dive headfirst into volatility ETFs.

You might consider them if you:
- Actively manage your portfolio
- Have decent risk tolerance
- Pay attention to macroeconomic trends
- Want to hedge short-term market risks

They’re not for passive investors who “set it and forget it.” These beasts need supervision.

Final Thoughts: Don't Let Panic Wreck Your Portfolio

At the end of the day, investing is about playing offense and defense. Volatility ETFs are your defensive line. They might not win the game for you, but they’ll stop you from getting crushed.

So when the markets start melting faster than ice cream in July, think about having some volatility ETFs in your toolbox. They’re not the perfect solution, but they can be a real lifesaver when the markets go full-on chaos mode.

Just remember—these are tools, not magic wands. Use them wisely, stay alert, and always have an exit strategy.