Protecting Your Capital During Market Sell-Offs. 6 ETFs That Work

by: Christopher F. Davis

Stocks have given up a lot of the gains that were a result of central bank action to bolster equities markets. It seems much of the market focus is on the economic turmoil the world still faces. Now that the U.S. presidential election has concluded, investor attention has returned to the terrible fiscal situation in Europe, which has now even begun to slow the German economy. Further, the reality of the fiscal cliff is coming in 53 days. Standard & Poor's says [the missed deadline] now has a 15% chance of occurring, and chances will be higher each day that passes with no action from Congress. The markets have been digesting the election results as if it were a bitter poison pill and the fears of Europe and the U.S. fiscal cliff have given the bears an edge over the bulls.

The sell-off has been led by Apple (NASDAQ:AAPL) which at the time of this writing is now deep into bear territory, trading at $540.97 down some 23.3% from its intraday high of $705.27 in September. Should the action in equities markets continue to be weak, as many are suggesting, more high quality blue chips may also be at risk. For the record, I believe AAPL is now at a strong level to begin initiating new positions. That said, it is likely to continue a descent along with the broader markets until we have some resolution in Europe and of the fiscal cliff in the U.S. A final piece of ammunition for the bears is that many professionals believe earnings estimates are too high and will not be beat frequently this quarter and next, thus they may be lowered in the coming weeks.

To preserve capital in these dangerous times, traders may want to put on some bearish positions to insure their portfolios. Those who are bearish could consider selling stock, selling covered calls on their positions, shorting stocks, buying puts or investing in a volatility or bear fund. While each of these approaches has its respective benefits and risks, in this article I want to offer investors six ETFs to consider, three volatility and three bear funds, that I believe could provide great short-term returns in the event of continued market sell-offs on disappointing earnings or international news.

Ipath S&P 500 Short-Term VIX futures ETN (NYSEARCA:VXX): The Chicago Board Options Exchange Market Volatility Index or the VIX, is a popular measure of the implied volatility of S&P 500 market index. You may hear it often referred to as the fear gauge or the fear index. The VIX is a measure that is supposed to represent the market's expectation of stock market volatility over the next 30-day period. The VXX is a fund that is one of the better ways to track the VIX (which is not directly available to invest in) in my opinion. This investment seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index 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. VXX recently underwent a major one for four reverse split to increase share value. The fund has an annual expense ratio of 0.89%, is currently trading at $37.20, and has a 52-week trading range of $32.48-$198.04.

VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX): This is my least favorite, but still effective play on very short-term volatility. The return on this fund is linked to twice the daily performance of the S&P 500 VIX Short-Term Futures. It was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. The calculation of the VIX is based on prices of put and call options on the S&P 500 Index. This fund has a 1.65% expense ratio and currently trades at $1.47 and has a 52 week range of $1.25-$64.68.

ProShares Ultra VIX Short-Term Fut ETF (NYSEARCA:UVXY): This is my favorite play when I expect short-term volatility to spike. The investment fund seeks to replicate (net of expenses) twice the return of the S&P 500 VIX Short-Term Futures index for a single day. The index measures the movements of a combination of VIX futures and is designed to track changes in the expectation for one month in the future. The fund has an expense ratio of 1.41%, currently trades at $31.73 and has a 52 week range of $25.04-$316.00. This wide range has been a result of multiple reverse stock splits conducted by the fund's managers.

Right now, volatility is quite low compared to historical levels; a few more pieces of bad news such as lackluster earnings or continued economic contagion in Europe could spark another sell-off. Further, volatility is likely to spike on political news as well, specifically as it pertains to the fiscal cliff. Consider picking up some units of these indexes or some in-the-money call options as a short-term play on anticipated volatility, should you expect another sell-off. Do not however buy and hold these funds as the contango associated with volatility futures contracts eats into the share price over time. They are short-term plays only.

Direxion Daily Small Cap Bear 3X Shares (NYSEARCA:TZA): This is my favorite way to invest in a bear market short-term. TZA seeks daily investment results of 300% of the inverse of the price performance of the Russell 2000 Index (also known as the small cap index). The Russell 2000 measures the performance of the small-cap segment of the United States equity universe and consists of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 10% of the total market capitalization of the Russell 3000 Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. TZA actually does not invest in equity securities or stocks. What TZA does is creates short positions by investing at least 80% of its net assets in financial instruments to provide leveraged and unleveraged exposure to the Small Cap Index and the remainder in money market instruments. TZA currently trades at $17.10 a share on average daily volume of 20 million shares. In the last month, TZA is up 15.7% compared with the ETF that tracks the Russell 2000 index (NYSEARCA:IWM), which currently trades at $79.13, down 5.3% in the last month. TZA has a 52-week range of $13.35-$39.68.

ProShares Short S&P500 (NYSEARCA:SH): This ETF seeks daily investment results that correspond to the inverse of the daily performance of the S&P 500 index. The S&P 500 index is a measure of large cap United States stock performance. It is a capitalization weighted index of 500 United States operating companies and selected real estate investment trusts." SH attempts to invest "at least 80% of its net assets, including any borrowings for investment purposes, to investments that, in combination, have economic characteristics that are inverse to those of the index. It intends to invest assets not invested in financial instruments, in debt instruments and/or money market instruments. The Fund intends to concentrate its investments in a particular industry or group of industries to approximately the same extent as the index is so concentrated.

SH currently trades at $35.45 on approximately 3.3 million shares exchanging hands daily. SH is up 5.3% in the last month, while the S&P 500, as measured by the (NYSEARCA:SPY) trades at $138.16, which is down 5.3% in the last month. SH has a 52-week range of $33.33-$44.22.

Direxion Daily S&P 500 Bear 3x ETF (NYSEARCA:SPXS): SPXS, formerly the Direxion Daily Large Cap Bear 3X fund, seeks daily investment results before fees and expenses of 300% of the inverse of the price performance of the S&P 500 Index. As with other funds there is no guarantee the fund will meet its stated investment objective. The fund has a 1.14% annual expense ratio. Under normal circumstances, SPXS management creates short positions by investing at least 80% of its net assets in: Futures contracts; options on securities, indices and futures contracts; equity caps, collars and floors; swap agreements; forward contracts; short positions; reverse repurchase agreements; ETFs; and other financial instruments that, in combination, provide leveraged and unleveraged exposure to the S&P 500.

SPXS currently trades at $19.26 a share. SPXS has average daily volume of 1.48 million shares exchanging hands. In the last month, SPXS is up 16.0% while the SPY at $138.16 is down 5.3%. SPXS has a 52-week trading range of $16.03-$40.84.

Bottom line: It's a lot easier to make the bear case than it is to make the bull case right now, in my opinion. There are lots of ways to position for this short-term bear market, including selling covered calls, buying puts, shorting stocks and stock indices, or just plain old selling equities to raise cash. Now that central bank action is becoming a distant memory, it is evident that trouble in Europe and the fiscal cliff will dictate the direction of the market. I think a short-term move to insure your portfolio against another sell-off is by playing volatility or trading a bearish ETF fund. Both the TZA bear fund and the UVXY volatility fund are my favorites to consider for short-term market sell-offs and/or panic.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am not recommending investors to be bullish, bearish or neutral. This article is for informational purposes only and highlights funds one can consider in the event or anticipation of short-term volatility and bearishness. It is not a recommendation to buy or sell any of the aforementioned assets.