VXX - Trading the volatility

The Stock: iPath S&P 500 VIX Short Term Futures ETN (VXX-N) Recent price: $43.15

Trend: With the distribution of Stock Trends indicators and the bearish trends of major market indexes marking this summer’s sobering shift in investor sentiment, the course ahead looks grim. And yet there are many commentators quick to take a positive view on equity valuations of many global enterprises. For them the market retreat is delivering a great opportunity to pick up cheap stocks. The months ahead will grade the wisdom of their optimism.

The financial market landscape looks daunting and conflicted. Capital markets are now exposing a tension between underlying structural stresses in the global economy, highlighted by sovereign debt crisis in both Europe and the U.S., and excess liquidity that is supported by highly accommodative monetary policy and strong corporate balance sheets. Heightened merger and acquisition activity in the equity market, headlined this week by Google’s aggressive move in extending its hand in the mobile handset market, and still impressive fundamentals for many corporations shows flush coffers and capital on the move even in the face of a sputtering economic recovery and slipping equity prices.

Currently, the most prominent positively trending issues in the stock market are inverse exchange traded funds – bearish bets against individual markets – and precious metal funds and stocks – a bearish bet against excessive liquidity. In one breath the market fears deflation and craves more liquidity, in another it fears inflation and hedges against it. Equally a sign of conflicted capital flows exists when investor safe havens are simultaneously gold, a financial commodity that is now approaching all-time inflation-adjusted highs, and U.S. Treasuries, a curious juxtaposition of faith considering the downgraded fiscal condition of U.S. public debt and the bearish long term trend of the world’s reserve currency.

Not surprisingly, the battling concerns about the economy and monetary stability have heightened market volatility. The CBOE Volatility (VIX) index, which measures the implied volatility of S&P 500 index options, has spiked to its level in June of 2010, another recent period of market crisis. Investors should expect this relatively high volatility to continue. For many or most retail investors the sidelines are the safest place to be. Value-minded investors will clamour toward companies in defensive sectors or stellar global names that have maintained relative performance amid market turmoil, while more sophisticated market timers will be embracing this volatility and trading aggressively.

The Trade: Another option for the more aggressive trader is to play the volatility itself. Canadian investors might consider the iPath S&P 500 VIX Short Term Futures exchange traded note, an instrument that seeks to replicate the movement of the underlying VIX futures index. Trading in these notes – listed also on the TSX (VXX-T) – has spiked with the increased market volatility, and the note price is now up 70 per cent in August. Traders convinced we are entering more of a financial market shakedown in the months ahead will anticipate even higher VIX readings. 

The Upside: Investors should consider this trade as more of an insurance instrument against market panic than a directional, trending trade. The bet here is that the peak of uncertainty will drive the VIX well past 2010’s second quarter high-water mark and that relatively high VIX readings will persist in the upcoming period. The VIX reading in the grimmest moments of the 2008 financial crisis was double the current level of the index.

The Downside: Spikes in the VIX more typically lead to traders anticipating a retreat in volatility, and they would short the index. To be sure, this is a high risk trade.