On Friday, the VIX traded down to a six-year low amid increasing market optimism. Investors should use this as an opportunity to make some important moves. And, there is one mistake investors must avoid.
It is possible that the VIX will remain at depressed levels for an extended period of time. That being said, it is inevitable that the VIX will spike higher at some point in the future. Be it a natural disaster, outbreak of unexpected war, a U.S. debt crisis, a Japanese debt crisis, a breakup of the EU, a computer driven flash crash, or some other unexpected event the VIX will surge. Even if the VIX does not move higher from here, the downside is quite limited. Perhaps, if all goes well in the world, the VIX could trade down to historic lows near 10, a more than 20% drop from current levels. While this may seem like a lot of downside, it pales in comparison to the upside which could easily send the VIX up 100-200% from current levels. Simply put, in my opinion, the risk reward scenario makes being long the VIX a good trade.
Avoid VIX ETFs & ETNs
Despite being bullish on the VIX itself at these levels, I remain negative on VIX ETFs and ETNs. The most popular VIX ETFs are iShares S&P 500 Short-Term Futures ETN (VXX), Velocity Shares Daily 2x VIX Short-Term ETN (TVIX), and ProShares Ultra VIX Short-Term Futures ETF (UVXY). Essentially, my concerns about these products remain. Since the time I joined Seeking Alpha in November 2011, I have written seven articles, all negative, on VIX related products:
VIX Futures Curve Means Trouble For VIX ETFs August 22, 2012
TVIX ETN Sell-Off Explained March 23, 2012
TVIX: Sell The Rally March 28, 2012
TVIX Surges, But Investors Should Stay Away June 22, 2012
TVIX Hits All-Time Low Despite Market Weakness July 2, 2012
TVIX Hits All-Time Low, But It's Not Too Late To Sell July 18, 2012
In short, I am bearish on these products because of a structural flaw with the products themselves. VIX products, especially spot VIX products, as I have discussed in all of my previous articles, are exposed to the contango in VIX futures. Currently, VIX futures remain in a steep contango. Yes, these products will "go up" strongly if the VIX spikes but they will not hold the gains. Any move higher in these products should be used as a chance to sell.
One way in which I do believe investors can take advantage of the low VIX is by buying put options as a hedge for long positions. The low VIX means that option premiums overall, especially puts, are relatively cheap. Simply put, investors should hedge because they do not know what the future holds.
At current prices, with the VIX at 6 year lows, buying puts as a hedge makes sense. If market conditions change, investors will be very happy to own the protection. If market conditions do not change, and the bull market continues, the loss will only be the premium paid which is relatively low right now. Despite being optimistic about the VIX itself, I remain bearish on VIX-related products because of their major flaws. The chart below shows why I do not like VIX ETFs and ETNs as hedges.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.