Volatility in the stock market is represented by the CBOE Volatility Index (VIX), also known as fear gauge. This tends to outperform when markets are falling or fear levels over the future are high. None of these has happened lately thanks to mixed economic indicators. As such, VIX plunged last week to its lowest level in 14 months, reflecting no fear or a greater complacency in the stock market.
Where Will VIX Go From Here?
While the S&P 500 index hit an all-time high of over $1,900, the Russell 2000 index has dropped 7.6% from the record high reached in March. The gains in large caps came despite the slide in growth stocks and concerns over the Chinese slowdown. This trend will likely continue on a gradually improving economy, strengthening job market and low interest rates.
Additionally, the latest upbeat economic data, such as unexpected rise in orders for durable goods, higher home prices and increasing consumer confidence, as well as corporate deals have spread some optimism. Apart from these, the yields on 10-year Treasuries have also reached lower levels despite the fact that the Fed is paring its asset program. All these factors might keep the fear levels down, pushing the volatility index even lower (read: 3 Bond ETFs Surging as Interest Rates Tumble).
However, uncertainty over the Fed policy, concerns over uneven economic growth and weak corporate earnings could flare up market volatility. This is especially true as the earnings estimates for the current quarter are coming down and the pace of negative revisions has accelerated in the recent days. Earnings for Q2 are now expected to be up 4.3% versus 5.5% in early April, as per the Zacks Earnings Trends.
Further, the stock market is seeing light stock-trading volumes over the past few days, indicating a bearish signal for the market as a whole and upward movement in VIX in the near term. Moreover, the S&P 500 has been trading in a tight range of around 4.8% over the past three months compared to an average of 13% range. The tight trading range suggests that the market might not continue to move higher in the coming days, providing some support to the volatility index.
If this wasn’t enough, investors should also note that fewer stocks hit new highs with the current booming market. According to the recent study, only 26 stocks on average have touched new highs over the past one-month compared to 101 in the same period a year ago. This indicates that the stock market might not be healthy going forward leading to sharp fall anytime soon (read: 3 ETFs Hitting All-time Highs in Rocky Market).
Volatility ETFs in Focus
Given this, investors should take great precaution while trading in volatility ETFs or use these products for hedging purpose to ensure safety when the stock market starts plunging.
A popular ETN option providing exposure to volatility, iPath S&P 500 VIX Short-Term Futures ETN (VXX - ETF report), sees a truly impressive volume level of about 32 million shares a day. The note has amassed over $1.2 billion in AUM and charges 89 bps in fees per year. The ETN focuses on the S&P 500 VIX Short-Term Futures Index, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. It provides investors with exposure to a daily rolling long position in the first and second month VIX futures contracts.
The two products – ProShares VIX Short-Term Futures ETF (VIXY - ETF report) and VelocityShares Daily Long VIX Short-Term ETN (VIIX - ETF report) – also track the same index. VIXY has $113.2 million in AUM and sees good average daily volume of 884,500 shares while VIIX is the unpopular of the two with just $8 million in its asset base and sees moderate volume of 106,000 shares per day.
The former charges 85 bps in annual fees while the latter is a little costlier, charging 0.89% annually from investors. The three products lost nearly 15.5% over the past one month (read: Volatility ETFs Crash as Market Fears Drop).
Another product – C-Tracks on Citi Volatility Index ETN (CVOL - ETF report) – linked to the Citi Volatility Index Total Return, provides investors with direct exposure to the implied volatility of large-cap U.S. stocks. The benchmark combines a daily rolling long exposure to the third and fourth month futures contracts on the VIX with short exposure to the S&P 500 Total Return Index.
The product has amassed $8.3 million in its asset base while charging 1.15% in annual fees from investors. The note trades in a small volume of less than 46,000 shares per day and lost nearly 20.6% in the trailing one-month period (read: 3 Hit and Flop ETFs of April).
In the chart below, we have considered the price movement of the ultra-popular VXX. The ETN made its 52-week low of $34.82 last week and its short-term moving average (9-Day EMA) is well below the mid and long terms (50 and 200-Day EMA), suggesting some pessimism on the product.
However, RSI of the note is below 20, suggesting that the product is in the oversold territory and has room for a strong run up in its prices in the coming months.
Given mixed signals from both macro and technical points of view, it seems prudent for investors to wait until the upside in stock market breaks out or some fear factor creeps into the picture (see: all the Volatility ETFs here).
Further, investors should note that these products are suitable only for short-term traders and have been terrible performers over medium and long term. This is because most of the time, the VIX futures market trades in ‘contango’, a condition in which near-term futures are cheaper than long-term futures contracts. Since volatility ETFs and ETNs like VXX must roll from month to month in order to avoid ‘delivery’, a contango situation can eat away returns over long periods.
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