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January was a month to forget for equity investors, as broad markets took a step back to start the year. Concerns over job growth, emerging markets, and the continuation of the taper weighed heavily on stocks in the month, and led some to believe that the bull run is finally nearing an end.
This sluggishness was further confirmed by the performance of volatility-linked (usually VIX-linked) investments as these have done pretty well over the past two weeks. This is a bit of a surprise as volatility Exchange Traded Products usually see terrible performances, though in rare times like the past 10 days they can really prove their worth for short-term oriented traders.
Volatility and the VIX in Focus
The VIX is often referred to as the ‘fear index’ and is thought of as a gauge of investor perception of the market’s risk. It is constructed using implied volatilities of S&P 500 index options, taking both calls and puts into account.
Generally speaking, this benchmark increases when fear levels are rising, and it slumps when markets are doing well and there is little prospect of risk events on the horizon (read Why I Hate Volatility ETFs).
While investors can’t directly buy up this index, there is a popular ETN option at our disposal that can give us some exposure to volatility, the iPath S&P 500 VIX Short-Term Futures ETN (VXX - ETF report). This product has nearly $1 billion in assets under management and it sees an average daily volume of over 18 million shares so trading in and out of VXX shouldn’t be too much of a problem.
The product has been a pretty poor performer over the past year though, as the solid market has curtailed the need for volatility-linked investments. Additionally, due to the nature of volatility, the underlying index’s futures contracts—which are the basis of this ETN—are generally in contango and thus it can be an uphill battle for long term investors in this type of product (see all the Volatility ETFs here).
Still, during short time periods, products like VXX can prove to be winners, and that has certainly been the case during this recent sell-off.
Selling Pressure Leads to VXX Gains
Over the past ten trading sessions, SPY has declined by about 3.4% in a steady downward move. Emerging market worries and the Fed’s escalation of the taper really hit the market hard, and have left many feeling bearish (and fearful) about the market’s near term outlook.
Thanks to this, VXX has been doing quite well on extreme amounts of volume. The product has actually added more than 21% in the past ten days, including a nearly 10% burst higher in Friday trading on volume that was over 69 million shares (see Volatility ETFs: Three Factors Investors Must Know).
And for the truly bold traders out there, two leveraged volatility products exist; the VelocityShares Daily 2x VIX Short Term ETN (TVIX - ETF report) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY - ETF report). These both added more than 16% in Friday trading, capping off a 10 day run of more than 40% each.
So clearly, it has been a very good time to be in the volatility market, though the ‘volatility of volatility’ is pretty high. The leveraged volatility products saw more than half of the gains disappear in one session, while Friday trading saw these losses erased as the S&P 500 tumbled again. Positions in this corner of the market need to be monitored closely, as after such a run in volatility we are probably due for a pullback soon.
When markets are sliding and investors are starting to become fearful, there are few investments that are better than volatility. As we have seen with the trio of VXX, TVIX, and UVXY, huge gains are possible in a very short time frame, and they can help to balance out weakness in other parts of a long-focused portfolio.
However, gains can evaporate as quickly as they come in the volatility market, so make sure to be nimble. The futures curve generally works against investors here, and long-term charts aren’t pretty for products like VXX, so make sure to only use these for short-term purposes.
If you are looking to apply a volatility-hedged strategy as part of a broader equity play, consider either the PowerShares S&P 500 Downside Hedged Portfolio (PHDG - ETF report) or the Barclays ETN+ S&P VEQTOR ETN (VQT - ETF report). Both of these follow a dynamic index which includes both equity and volatility components, shifting towards volatility as volatility levels rise (see Two Hedged ETFs Built for Rocky Markets).
This technique costs a lot more than a simple investment in the S&P 500, and it can often underperform broad markets. However, during times when volatility is rising, this approach can earn its keep in a big way, suggesting that some who are fearful—but aren’t willing to tolerate the big moves in VXX and the like—might want to look to these products instead for a ‘safer’ way to play volatility in today’s uncertain market.
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