How to Stay Afloat When The Markets Are Sinking
The Great Recession may have officially ended, but the economy is still not looking too hot. U.S. unemployment is still above 8 percent and the stock market experienced its biggest drop of the year just a couple weeks ago, pushing the Dow into negative territory for 2012. The global economy is not fairing well either, to say the least, especially in Europe. Greek elections, which are coming up this month, will be the deciding factor in determining whether the “Grexit”, Greece’s departure from the Eurozone, will actually happen. Meanwhile, Spain, the Eurozone’s fourth largest economy, was just downgraded by Fitch to BBB and may soon be receiving a bailout of up to 100 Billion Euros, while its 10 year bond yields have soared to over 6 percent. No one knows where the global economy is going, so now is the time to safeguard your portfolio from crashing even if the world does.
There are countless combinations of derivative contracts investors can use for hedging purposes. But for the average investor who wants to take an all-equity approach, the iPath S&P 500 VIX Short-Term Futures ETN (Amex: VXX) is a great option. If you are investing in VXX, you are really after the VIX index. The VIX spot price is an index reflecting implied market volatility from puts and calls on the S&P 500 index. To learn more about the intricacies of options, read this article. When investors are more bearish on the economy, they buy more put options, causing implied volatility to go up and therefore the VIX index.
Because the VIX cannot be traded, many investors buy futures contracts on the VIX. It is possible to buy contracts for futures expiring next month and the 8 months following. The VXX ETN is made up of two months of VIX futures – the ‘near’ month and the ‘following’ month. Every day, the portfolio is rebalanced with an equal number of contracts for the near month being sold as the number bought for the following month. Besides fluctuations of the VIX index, the price of the VXX also depends on the price differential between these two futures contracts. For this reason, the VXX does not move completely in tandem with the VIX. The price differential could, of course, be in the investor’s favor.
In contemporary financial literature, two terms that are often penned with no real explanation are ‘contango’ and ‘backwardation’. Volatility is said to be exhibiting contango when futures are more expensive in the following month, while ‘backwardation’ occurs when the near month is more expensive. Because the VXX ETN sells contracts for the near month and buys for the following month, investors with VXX currently in their portfolio seek backwardation. Looking forward, if backwardation does occur in the next month, which some analysts say is fairly likely, the VXX may spike over 50 percent. About one year ago, in fact, the VXX doubled in just one month.
Although a buy-and-hold strategy is not recommended for VXX, it is a great tool for short terms gains from heightened uncertainty in the economy. The VXX has a -2.5 beta coefficient, which means that it has historically had a negative correlation with the S&P that is amplified 2.5X. Last month, the S&P was down about 2.5 percent while VXX was up around 7 percent, which can be seen in the graph below.
With the possibility of a Greek exit from the Eurozone, Spain’s debt-burdened economy needing more aid, slowing emerging market economies, and consistently disappointing economic data in the U.S., the VXX can be a great hedge to protect investors’ portfolios this summer.
While the VXX is the largest VIX product, there are other ETNs available, which vary by maturity and leverage. The iPath S&P 500 VIX Mid-Term Futures ETN (Amex: VXZ) is similar to the VXX, except embedded are the fourth through seventh month VIX futures instead of the first two months. This makes VXZ much more reliant on future volatility and investors typically do not foresee market movement so far in advance. For a riskier spin on VXX, the VelocityShares Daily 2x VIX Short-Term ETN (Amex: TVIX) offers higher leverage, which means a higher upside and downside. However, leverage can get expensive and the same portfolio rebalancing issue as with VXX exists, causing many investors to stay away. The prospectus for TVIX even warns investors that there is a high likelihood of a substantial portion of the investment to be lost. In times of decreasing volatility, many investors flock to iPath Inverse S&P 500 VIX Short-Term ETN (Amex: XXV), which seeks to replicate a short position on VXX. In general, investors prefer to have long positions than shorts because a short position involves borrowing a security from a broker, which requires additional fees. While all of these of equity hedging alternatives and more exist, investors commonly either stick to trading VXX or initiate desired positions with option contracts.
Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.