Are You Ready To Take Advantage Of Increased Volatility?

by: Kevin Quon

Like rounding the last lap of this racetrack known as 2012, the passing of Christmas marks the nearing end of the calendar year. Once again, the time comes to ponder the consequences for the upcoming tax season. Yet unlike years prior, the close of 2012 makes for a special circumstance. For the most part, investors remain fully aware that 2013 will almost inevitably see a rise in taxes on capital gains. As a result, they may not only be seeking to sell their losses this year for a favorable tax outcome, but could also be pulling the trigger early when considering to take their capital gains.

While this in itself may not necessarily serve as the impetus for increased volatility, it undoubtedly helps support it. The fact remains that tax uncertainty is one of the many unresolved questions continuing to linger as the market wonders what to expect next. The supposed "fiscal cliff" continues to sound more ominous than it likely really is, but in itself the deadline serves as a doomsday ultimatum by which fear abounds through uncertainty. With political partisanship holding onto a stalemate of both the country and the economy alike, the run-up to the first of January has done little to ease the tensions found on Wall Street.

In the last few months alone, volatility has steadily been increasing as a result of this situation. This can be seen in the graph of the Volatility S&P 500 Index (VIX) found below. The VIX is quoted in percentage points and roughly equates to the expected movement in the S&P 500 index over the next 30-day period when annualized. As of December 26, the VIX was at $19.48, which was indicative of a 5.62% move in the S&P 500 over the next 30-day period. Today (Wednesday) alone, the volatility index spiked over 9%.

It remains debatable whether or not the volatility will continue to rise higher in the coming days. In all likeliness the outcome of the fiscal cliff situation will have a significant role in determining future volatility. Yet what remains undeniable regardless of the outcome is the fact that preparing for such increased volatility's abatement can be a very profitable endeavor in itself. After all, there is much money to be made in the process of normalization.

Investors should keep their eyes on investments that specialize in volatility. Take the iPath S&P 500 VIX ST Futures ETN (VXX) for instance. Due to contango, this ETN tends to continuously drift lower as it daily rolls over long positions in the first and second month VIX futures contracts. Over the long-term, contango and the improbability of a consistently fearful market dictate the downward trend of the investment. As seen in the graph below, such a trend has been well defined for many years. It also continues to be prolonged through reverse splits.

Shorting the VXX remains a seemingly safe strategy to incorporate for longer periods of time. As volatility increases, investors are given the chance to prepare for another attractive entry point as the VXX correspondingly rises. Taking a short position in such an investment can be ideal as increased volatility peaks and subsequently dies down. Similar trends can be found in leveraged investments that track volatility such as the VelocityShares Daily 2x VIX ST ETN (TVIX) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY). While more volatile investments, the TVIX and the UVXY trends very close according to their designed intention as seen in the graph below.

TVIX Chart

TVIX data by YCharts

Two additional investments to consider would be the VelocityShares Daily Inverse VIX ST ETN (XIV) and the VelocityShares Daily Inverse VIX MT ETN (ZIV). Yet rather than shorting these investments at the peak of volatility, investors would consider going long. These investments seek to replicate the inverse of the indexes they track. By going long on the XIV or the ZIV, investors are able to mimic a similar effect as shorting the VXX. Such a mirrored contrast between these investments can be seen in the graphic below. In essence, such a strategy can add the benefit of limiting the downside loss potential that always lingers over a short position. It also allows for investors to correctly add exposure to normalizing volatility who might not have been able to add short positions into their brokerage accounts.

VXX Chart

VXX data by YCharts

Overall, understanding the concept of contango allows for a unique opportunity when it comes to volatility. Probability dictates that volatility will eventually normalize, barring the end of the market itself. As a result, knowing when increased volatility is to occur and more importantly identifying when it's about to peak allows investors to exploit the situation by investing at attractive entry points. With increased uncertainty existing on the market today, investors should pay keen attention to the VIX.

As already shown, the latest trend suggests that volatility has been steadily increasing. The impending fiscal cliff resolution deadline offers a rare timeline for which readers should consider their positions in volatility. Should the resolution appeal to the market, volatility is bound to decline. The opposite is likely true should the outcome not be amicable. As a result, investors might be wise to slowly average into their positions over the coming week and beyond. One doesn't need to necessarily predict the future result in order to invest into a solid trend at an opportune time.

Disclosure: I am long XIV, ZIV. 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.

Additional disclosure: I am also short VXX