Market Pain To Continue: Volatility Is Back And Can Deliver Profits

| About: iPath S&P (VXX)

Is this Fed-pumped stock market topping out? We are still near all-time highs in the U.S., but global markets are feeling the pain. That pain is likely to continue and could affect the U.S. markets. At the time of this writing, the Dow is at 15,000.10 and the S&P 500 is at 1613.60. With the Dow Jones ETF (NYSEARCA:DIA) at $149.77 and the SPDR S&P 500 ETF (NYSEARCA:SPY) also a few points off its highs at $162.01 after some nasty and volatile sessions, we have to question how we got here. It is an important time to reassess how we arrived to records highs, especially watching global markets fall apart in just weeks. Look at Japan (NYSEARCA:EWJ), for instance, which is now in bear market territory after skyrocketing in 2013. Here in the U.S., the economy has not really rebounded all that strongly and continues to limp along with sub-2% growth and anemic job numbers. There are some bright spots, but the market seemingly has been propped up by the actions of central banks.

Central Banks Pumped Stocks Up, Now Beginning to Deflate

In late summer 2012, the European Central Bank announced an unlimited short-term bond-buying program with some conditions, reinforcing its position to do all it can to save the euro. Following this, Ben Bernanke and the U.S. Federal Reserve announced a massive third round of quantitative easing, aka QE3, consisting of buying $40 billion in mortgage assets monthly until unemployment improves. Even the Bank of Japan is on board the central bank stimulus train, having announced its own round of easing last year and other massive stimulus projects in the last few months. Then the Fed announced it would accelerate its debt-buying program to spend another $40 billion to $45 billion a month in balance sheet expansion to replace Operation Twist.

This action has been excellent for stocks. American and Japanese markets have been on fire, up until last week. Economic data in the U.S. is still rather weak. Aprils' jobs number report showed 88,000 jobs added when analysts expected 200,000. May's number of 165,000 for jobs added in April, however, was strong and the unemployment rate remained at 7.5%, which is still unacceptably high. The June jobs number was 175,000 added, but unemployment was at 7.6%. These are positive, but in a real recovery we should be seeing numbers of 300, 400 or even 500,000.

Fears in Europe are also returning as European economies are contracting. France is officially in recession and other country's economies in Europe are just limping along. Earnings have been decent this season, but future earnings estimates may be too high and these weak economic reports should give investors pause.

What is really driving the action and just taking the air out of markets? It is speculation that the Fed will taper its asset purchases, which has made volatility spike in the last few weeks. Their purchases pumped markets up, but now the fear that they will taper early has just led to volatile selling. It is important to note that they haven't even announced a change. Still, the markets are reacting. Given the weakness, more volatility is likely to persist, especially if we see a long overdue correction, which we are flirting with after several percentage point drops in the averages.

Profiting on the Volatility

To take some protective action, traders may want to put on some bearish positions. Those who are bearish could consider selling stock, selling covered calls on their positions, shorting stocks or buying puts. While each of these approaches has its respective benefits and risks, in this article I want to highlight a volatility fund that could provide great short-term returns in the event of a market sell-off on disappointing earnings, domestic debates that raise fear levels, or other international turmoil. These types of funds have performed terribly in 2012 and in 2013 as the market has seen record low volatility and extreme positive action. If volatility remains with us due to fear in the market, there is one fund I recommend that can provide extreme short-term returns. This fund is the iPath S&P 500 Short-Term VIX futures ETN (NYSEARCA:VXX).

The VXX is a tool that tracks the Chicago Board Options Exchange Market Volatility Index, or the VIX, which is a popular measure of the implied volatility of S&P 500 market 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), than many of the other leveraged volatility ETNs. Leveraged volatility funds, including the VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX), are to be avoided as they tend to lose value rapidly due to contango. TVIX has lost over 90% of its value in a few short years.

The VXX as an 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." As part of this approach, the index futures roll continuously throughout each month, from the first month VIX futures contract into the second month VIX futures contract. While volatility has not been an attractive play of late, it has been gaining steam.

Investors Pile Into VXX

The increasing swings in global stocks, both up and down, have prompted VXX traders to make some extreme unprecedented bets on volatility, pushing bullish and bearish options contracts to records amid concern the Fed will curtail stimulus and the action that has been seen in markets as a result. Options outstanding on the Short-Term Futures VIX, tracking a gauge of VIX futures, climbed to an all-time high of 3.46 million on June 11, based on data compiled by Bloomberg. The CBOE VIX has gained 56% since hitting a six-year low in low in March.

Investors are using contracts on the VIX, especially the VXX, which has seen volume increase by several hundred thousand shares a day in recent trading, to hedge stock-market swings as they continue to assess economic data and statements from policy makers on whether the Fed's bond purchases will be maintained or reduced. In fact, the SPY has had 1% or greater moves in either direction six times in the last few weeks. This is a key sign volatility is back in the market. However, VXX and similar products had been crushed in the last few years of this bull market as volatility was seemingly non-existent.

To curb the negative sentiment of a sub-$10 VXX price and to make it more attractive to investors, the VXX recently underwent a major one-for-four reverse split to increase share value. The fund has an annual expense ratio of 0.89%, and is currently trading at $21.02. It has a 52-week trading range of $17.97-$83.04 (please note this range does not account for shares reverse splitting). The recent rise in volatility has resulted in the VXX climbing $3.05 at the time of this writing, or 16.9%. If the volatility continues, I can see this trend continuing.

Bottom Line: While central bank action has bolstered markets for the last few months, volatility has been quite low. With the prospect that the Fed could taper its asset purchases, in the last few weeks it has been on the rise. A few more pieces of news that the market perceives negatively could push volatility higher. Should volatility continue to spike, picking up some units of the VXX or some in the money call options as short-term plays could deliver large profits in a short time frame.

Do not, however, buy and hold the fund for more than a month or so, as the contango associated with volatility futures contracts eats into the share price over time. It is a short-term play only. I think a short-term move to make in your portfolio if market panic ensues and stocks sell off is to play this volatility fund, and thus you can consider the VXX as a trade.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VXX over the next 72 hours. I frequently trade the VXX both long and short, generally holding for no more than two weeks at a time. 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 be bullish, bearish, or neutral. This article is for informational purposes only and highlights a fund one can consider in the event of, or anticipation of, short-term volatility and bearishness. It is not a recommendation to buy or sell any of the aforementioned assets.