Trade European volatility through the VSTOXX

Investors seeking to mitigate against European stock market turbulence should consider trading the VSTOXX, the benchmark volatility measure in Europe.

This is according to Nathan Bance, director in UK investor solutions at Barclays Capital.

Bance said investors seeking to hedge equity portfolios against volatility have traditionally done so via the VIX, the long established ‘fear gauge' of Wall Street, which measures the market's expectations of the short-term volatility of the S&P 500 Index.

While he said this trade makes sense for investors with significant exposure to US equities, Bance argued investors with exposure to European markets should seek to isolate European volatility through the VSTOXX, which measures the implied volatility of the DJ Euro STOXX 50 index, Europe's leading Blue-chip index.

"The VIX and the VSTOXX are seen as highly correlated but that has not always held true, and it seems increasingly unlikely to hold true in future," he said. "European and US stock markets seem to be diverging and that means investors seeking to protect themselves against volatility in the European market should consider trading the VSTOXX rather than the VIX, which is much less sensitive to the turmoil in Europe."

As neither measure is directly investable, investors seeking exposure to the VSTOXX and VIX Indices must do so via futures contracts. Until 2009, Bance said a relative dearth of listed futures on the VSTOXX and a lack of liquidity presented challenges for investors seeking to trade European volatility. But he said both issues have been resolved with an upsurge of futures being listed on the VSTOXX over the past two years.

"Before 2009 there were some short-term futures on the VSTOXX but these were thinly traded as investors were concerned about the lack of liquidity," he said. "Over the course of 2010, however, there was a big increase in the number of futures listed on the VSTOXX, which offered investors more choice and much better liquidity - something that has improved exponentially over time."

Moreover, with the launch of Exchange Traded Notes into the European market in 2010, Bance pointed out investors now have a cost efficient and straightforward route to access European volatility.

"Until the launch of VSTOXX ETNs not every category of investors in Europe could realistically invest in volatility," he said. "ETNs have simplified the market and represent the easiest way for investors to trade volatility as they can be bought and sold like a stock. They also free investors from the need to buy and sell futures themselves, which can be complex and relatively expensive."