Last Monday it was Russia, and WSD Insiders walked away with profits by trading prior to the elections and selling on the news.
On Tuesday, it was Greece (again), as rumors of pending default were making the rounds.
The Institute of International Finance estimated a staggering one trillion euros of financial impact in the event of a Greek default.
We also saw oil prices ratchet higher on saber rattling with Iran.
Gold and silver took a dive, too. And the U.S. market began to show something that’s been absent for several months: fear.
As is always the case when the market moves quickly higher, the index that measures volatility, the VIX, has been moving sharply lower. In fact, the VIX has dropped by more than 50% since the fall of 2011 – a huge move down as investors embraced the strengthening U.S. economy and the progress made by the Europeans on the bailout.
Now in the mid-teens, such a level on the VIX implies investor complacency (more on that later).
The VIX, for the uninitiated among you, trades in ranges that have historically suggested how profits can be made.
At inflated levels, above 35, it signifies that investors are nervous and are prone to sell.
Over 40 is an indication that investors are panicking, which means it’s time to buy stocks or go short.
When the VIX is under 20, it’s telling us that investors are complacent. So either think about protection or go long on volatility.
But here’s the problem: Investors can remain complacent for an indeterminate amount of time.
For example, I’ve seen the VIX stay below 20 for more than a year during bull markets, and that can lead to losses trying to trade volatility. That being said, it pays to know how to trade volatility before it becomes the norm.
Look at last week’s selloff – the worst of the year. It may have been a one-day event, or it could signal that there’s a correction in the works.
If the latter is true – and I suspect that it is – then you can make money three ways…
Three Great Volatility Plays
Volatility Play #1: Buy a Volatility ETF. I recommend buying the iPath S&P 500 VIX Short Term Futures (NYSE: VXX). It trades with about a 70% correlation with the VIX. It doesn’t have a 100% correlation because it uses futures on the VIX and those futures don’t move in lockstep with the Index. As the VIX moves higher, so does the VXX.
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Keep in mind, however, that there’s some bleeding in the VXX due to fees and time-value deterioration. But when the VIX is moving, so is the VXX.
Like any ETF that trades based on the underlying futures contract, the VXX resets daily and shouldn’t be used as a long-term trading vehicle.
Volatility Play #2: Buy options on the VXX. This is actually quite a bit cheaper than buying shares of the VXX and it can give you a much bigger bang for the buck.
Options are available for the VXX going out several months. If you think the VIX is going higher, buy call options on the VXX. If you think the VIX is going lower, buy put options. (I believe the VIX will move higher.)
Volatility Play #3: Buy a leveraged ETF on the VIX. In this case, the best one to buy is the TVIX (Nasdaq: TVIX), which moves on the VIX each day by a multiple of two.
Like the VXX, it’s also subject to “bleed” because it uses underlying instruments with an element of time decay. However, TVIX gives you the most value on the dollar if you’re right on your bet. It also resets daily.
Bottom Line: Volatility can be used as both a trading tool and as a hedge. However, you need to be aware of the VIX’s ranges and the array of choices available to both profit from volatility and to use for protection.
Ahead of the tape,