For much of the year, stock market volatility has been quiet and almost non-existent. But Europe’s ongoing financial crisis has triggered a massive surge in volatility.
Last week the Dow Jones Industrials (NYSEArca: DIA) recorded a 1,000 point intra-day fall. Other market global barometers like the MSCI EAFE index (NYSEArca: VEA) and emerging markets (NYSEArca: VWO) followed suit. As fear gripped the market, the VIX (Chicago Options: ^VIX) surged.
Contrary to popular opinion, volatility isn’t necessarily bad. In fact, some investors and traders are profiting from it. Let’s analyze three ways to ride the volatility wave.
Options are contracts that allow investors to go long (calls) or go short (puts) on securities. Instead of buying shares of a stock or ETF outright, a call or put option on the underlying security can be purchased at a fraction of the price. This gives the investor leverage because they’re controlling shares of a stock or ETF for a certain period of time in exchange for a premium payment. A bullish investor would buy calls whereas bearish investors would purchase puts.
Another way to think about options is as a form of insurance. When is the cost of insurance or your premium payments usually the most expensive? It’s when the threat of losses is high.
Similarly, the cost of insurance or options premiums are more expensive when market volatility is high, like it is right now. Put another way, selling options to collect high options premiums is one way to ride the volatility wave.
Buying leveraged long/short ETFs are another way to play rising market volatility. These types of ETFs attempt to magnify the daily gains of their underlying benchmarks usually by 200 or 300 percent. So long as you’re OK with market volatility, leveraged long/short ETFs can usually get the job done, regardless of whether you’re bullish or bearish.
The ProShares UltraShort S&P 500 ETF (NYSEArca: SDS), for example, attempts to double the daily opposite performance of the S&P 500. If the S&P 500 declines by one percent on any given day, SDS should theoretically rise by 2 percent.
Funds like the Direxion Daily Large Cap Bull 3x Shares (NYSEArca: BGU) aim for triple daily performance of large cap stocks. If large cap stocks rise by one percent on a certain day, BGU should record a three percent gain.
Play the VIX
The VIX indicator has become a popular gauge of investor fear and complacency. A high VIX reading signals fear whereas a low reading means increasing risk appetite among investors. How does the VIX work? By using a weighted blend of various S&P index options, the VIX attempts to estimate the implied volatility for the S&P 500 over the next 30 days. After recently touching 52-week lows, the VIX spiked and now sits around 30.13.
Another way to ride the volatility wave is through the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX) which is linked to the S&P 500 VIX Short-Term Futures Index. VXX offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract.
One caveat about VXX and all ETNs: They carry credit risk just like bond investments. Therefore, anyone investing in VXX would do well to closely monitor Barclays Bank’s credit situation. If it suddenly changes for the worse, it may be time to bail.
The EU’s $1 trillion plan to backstop the euro dollar (NYSEArca: FXE) has already been heralded by some observers as the panacea for Europe’s problems. Others have their doubts.
So as bulls and bears debate about what this means for the future of world markets, one thing we can all probably agree on is that chaos and volatility is here to stay.