Why Not Profit from Market Volatility?

09/13/2011 9:30 am EST

Focus: ETFS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

This exchange traded note is a good hedge because it runs up when everything else is looking down, writes Ben Shepherd of Personal Finance.

Since Standard & Poor’s downgraded the US government’s credit rating in July, the S&P 500 has experienced more down days than up days, providing additional fuel for bearish pundits who prognosticate that the US is on the cusp of a second depression.

Although we’ve long warned that this recovery would prove uneven and lackluster relative to prior postwar rebounds, we still expect the US economy to firm up in coming months. That being said, investors need to protect their portfolios against the volatility that’s part and parcel of a slow-growth environment.

S&P 500 VIX Short-Term Futures (VXX) runs up when things are looking down. This exchange-traded product can assuage your anxiety when the stock market tumbles and the media reports that the sky is falling.

Many individual investors had never heard of the Chicago Board Options Exchange Volatility Index (VIX) prior to 2008. Created in 2004, the VIX consists of futures contracts that track the implied volatility of S&P 500 options over a 30-day period. This so-called Fear Index exhibits a negative correlation with equity prices: When the S&P 500 declines, the VIX increases in value.

Professional money managers rely heavily on VIX futures to hedge against volatility and downside risk. Now Main Street investors can implement a similar strategy by buying one of several exchange-traded products that replicate movements in the VIX.

We prefer S&P 500 VIX Short-Term Futures, an exchange-traded note (ETN) that tracks the performance of a basket of short-term VIX futures with an average maturity of one month. The ETN exhibits a negative correlation to the S&P 500, and appreciates in value when the popular market index declines. By the same token, the ETN treads water when the S&P 500 turns in a flat performance, and loses value when the index rises.

Although the ETN charges an expense ratio of 0.89%, this hedging instrument limits your tax exposure relative to other options. You only pay capital gains when you sell your position. Buy S&P 500 VIX Short-Term Futures when you want to hedge against short-term volatility.

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