Selling Volatility Into Panicked Market

08/12/2011 10:52 am EST

Focus: ETFS

Igor Greenwald

Chief Investment Strategist, MLP Profits

The past week’s epic market moves argue for tempting bets on calmer times ahead, writes senior editor Igor Greenwald.

The markets offer no guarantees, but this much is almost certain: Despite the evidence from this unprecedented week, the Dow won’t keep lurching 400-plus points a day forever.

Recession or recovery, bull market or bear, the extreme volatility bedeviling investors of late is sure to abate. Fortuitously, the global casino now provides several convenient ways to play that hunch.

I’m long the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), which seeks to perform the opposite of one-month futures on the CBOE Options Volatility Index, or VIX. (The VIX measures volatility expectations, as implied by the prices of options on stocks in the S&P 500.)

Often referred to as the “fear gauge,” the VIX topped out at 48 this week, roughly the level it tagged during last year’s flash crash, but barely half of the epic spike at the October 2008 market low.

By Thursday, that was down to 39 and figures to go lower before the weekend if stocks deliver on this morning’s promise of further relief gains.

And there’s plenty of scope for additional declines in the VIX. The 50-day moving average is below 22, while the 200-day has only just crept up above 19.

I know, I know: volatility is the new black. So how smart is it to bet against it at this point?

The economy is arguably in trouble, many European banks can only borrow from central banks, and every single Republican presidential candidate proposes to balance the budget exclusively through growth-sapping spending cuts.

Plus, all the insider buying in the world (and there has been lots lately) can’t erase the fact that the major averages are in uncharted territory, tunneling well below the recent bull-market’s uptrend channel on the charts.

So investors are clearly operating in a different market environment than the one that pertained for most of the past two and a half years. It could prove an aberration like last summer’s panic. Or it could usher in even worse news.

The jury’s out on that trillion-dollar puzzler.

But the wide-range yo-yoing we’ve seen this week is typical of the market action at near-term bottoms. And volatility expectations appear to be among the most mean-reverting market phenomena.

After last year’s flash crash, it took VIX a month to drop to its 200-day moving average. After the August 2007 spike heralding the onset on the financial crisis, the reversion to that particular mean required seven weeks. Even after its moon shot in October 2008, the VIX was down 59% within six weeks.

So odds are pretty good that we’ll see a significantly lower VIX within a relatively short time. An inverse vehicle like XIV should benefit.

Needless to say, you should pay through the nose for even thinking about such a roll of the dice by reading the 159-page prospectus put out by the XIV’s issuer, VelocityShares, aka Credit Suisse (CS).

To highlight the main risks, volatility ETNs are highly likely to lose value over long (and sometimes very short) stretches of time, are subject to tracking error relative to the indexes they follow, and also to counter-party risk. Which is to say that even if you are long volatility via another Credit Suisse ETN, and volatility goes sky-high after Credit Suisse goes belly up, the ETN will go to zero.

All of these are good reasons to consider shorting long-volatility ETNs instead, for those able to do so. (Some of these shares have been hard to borrow in the past, and I have no knowledge about their current availability at the various brokerages.)

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) lost 86% between late May of 2010 and early July 2011. It’s up nearly 60% since July 22, but that’s almost certainly a temporary reprieve.

And then there’s the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), also from Credit Suisse, which has the potential to leave behind twice as many widows (and widowers) in its wake. The TVIX began the year at 65, was down to 17 in late July, but spiked to 47 this week before pulling back to the current 37. It’s going to be a teenager again real soon, most likely.

Short-term volatility expectations for equities should decline over the next month or two. And I can’t think of another financial prediction I can make with anywhere close to the same level of confidence.

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