3 Ways To Profit Big On This Correction

Includes: SPXS, TVIX, TZA, VXX
by: Christopher F. Davis

Is the bull market about to perish? Are we setting up for a bearish year despite all of the jubilant expectations that investors brought into this New Year? It may be too early to tell, but here are the facts. A large correction is what traders and investors are fearing after the Dow Jones Industrial Average and S&P 500 Index dropped 3.5% and 2.6% respectively last week. Capped by Friday's rout, last week marked the Dow's worst trading week since November 2011 and the S&P's biggest weekly drop since June 2012. Last week certainly gave many investors reason to pause and restrategize, but one down week can easily be broken by positive earnings reports and economic data.

Caterpillar's (NYSE:CAT) announcement on 1/27/14 that its fourth-quarter profit rose 44% helped push the markets back into positive territory, but the market quickly turned south. This is not a good sign. The plain fact is that the market has been pumped up by an overly accommodative Fed. The euphoria is fading. Market sentiment is worsening despite market pundits trying to calm the waves. You see the disagreements brewing on financial news. While this isn't a 2008 situation, it's definitely shaping up to be a potential large correction. 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 several funds that could provide great short-term returns in the event of a market sell-off. These types of funds performed terribly in 2012 and in 2013 as the market saw up-day after up-day as well as record low volatility.

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 the 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. The VXX recently underwent a one-for-four reverse split to increase share value. The fund has an annual expense ratio of 0.89%, and is currently trading at $46.82. It has a 52-week trading range of $39.85-$107.24 (please note this range does not account for shares reverse splitting). The recent rise in volatility has resulted in the VXX climbing $2.00 today at the time of this writing and $6.00 in the last week. Expect volatility to remain in this market.

Direxion Daily S&P 500 Bear 3x ETF (NYSEARCA:SPXS)

For those individuals reading this article with the highest appetite for risk (aside from investors who are willing to short stocks) the SPXS can be considered for heavily leveraged bearish exposure to large cap stocks. 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 and is subject to slippage as described above. The fund also has a higher 1.14% annual expense ratio. The SPXS management team likes to create 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. Given this approach, in times of market sell-offs, the SPXS will deliver outsized returns. Thus, this fund should be considered by those who seek to profit from panic that could result from a fast sell-off that jolts the market. Like other leveraged bear funds during this time of market exuberance, SPXS recently underwent its own reverse split. SPXS currently trades at $36.86 a share. SPXS has average daily volume of 1.3 million shares exchanging hands. SPXS has a 52-week trading range of $32.96-$73.10.

Direxion Daily Small Cap Bear 3X Shares (NYSEARCA:TZA): This is my favorite way to invest in a bear market short term. It is also of the highest risk category, given its leveraged nature. TZA management seeks daily investment results of 300% of the inverse of the price performance of the Russell 2000 Index that tracks small cap stocks. 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 also recently underwent a reverse split in response to the bull market powering ever higher. It currently trades at $18.56 a share on average daily volume of 10.9 million shares. TZA has a 52-week range of $16.02-$45.80.

Take home message: Don't panic. There is nothing wrong with profit taking. Market sentiment is worsening, but we don't need to dump positions all at once here. A large correction could be brewing especially after today's rally completely fizzled after really good news from CAT. To offset potential losses (or to scoop up some gains) I recommend these three funds that do incredibly well during corrections. They are each up over 10% in a few short sessions and this uptrend will continue as the market sells off.

Disclosure: I am long VXX. 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.