Monthly Archives: August 2011

Using the New Volatility ETFs

Understanding Stock Market Volatility and the New Volatility ETFs.

Volatility in the stock market is what makes investors nervous. Without volatility, though stock prices couldn’t rise. Volatility is defined as the standard deviation of stock returns. It’s the downside volatility of the market that causes fear.

A recent development in the rapidly expanding ETF universe has been the creation of funds that reflect different measures of market volatility. These funds can be an effective hedging tool against portfolio declines when used properly.

The most commonly referred to measure of market volatility is VIX, which is a measure of the implied volatility of option contracts on the S&P 500. The VIX is also known as the “fear index.” The VIX will have a high reading when market participants are fearful and be low when the market is strong and there is a sense of complacency.

There have been numerous academic studies done on using the VIX to hedge equity portfolios. Goldman Sachs did one that concluded that VIX options could be a very effective portfolio management tool for risk reduction.

So how can an individual investor use the VIX for portfolio protection? Not too long ago, an investor would have had to buy and roll call options on the VIX index. This process worked well, but one had to consider the time decay of the options and the term structure. VIX options are based on the VIX futures, so each month’s option series correlates to that month’s futures contract. Some months may be priced higher or lower than another depending on the outlook of market participants. A strategy of rolling call options could be difficult for individual investors to implement effectively.

Today, an investor who wants a hedge and who doesn’t want a short position or an option position with time decay can purchase shares of the volatility ETF, the VXX when it is near the low end of its historical trading range. The VXX can be held indefinitely, just like a mutual fund. Once the VXX position has been purchased, it is held until something happens to the market to increase the volatility. If the market gets spooked by bad earnings reports, poor economic data, or unforeseen global events like natural disasters, war, terrorist attacks, etc, the VIX will spike and profits can be realized from the VXX position which can help to offset declines in a long term portfolio.