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Executive summary:

  • The VIX Index is nearing its critical support level of 12.
  • The VIX-related ETFs do an awful job tracking the VIX Index, but are good for tactical models and temporary portfolio insurance.
  • Developing events overseas and the US stock markets coming off all-time highs may represent a good opportunity to justify buying short-term portfolio insurance.

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I recently wrote a few articles to address situations just like today. The article detailed a tactical "portfolio insurance" strategy using the various VIX ETFs to hedge portfolios against unexpected "exogenous" events.

Manufactured political crises, temporary weather related events, unexpected bankruptcies of major corporations and heightened tensions between hostile nations can all serve as "exogenous" events that provide unique opportunities for investors. Once the SNP 500's volatility has spiked, investors interested in the "exogenous" trading theory should start looking for an investment strategy to capitalize on the "return to normalcy."

The tactical model detailed identified support levels of the VIX Index, and would trigger buy orders anytime there was a fear that an "exogenous" and unexpected event would occur. This last week was perfect. Last Friday, Alexander Putin began to flex his muscles about the developments in Ukraine. The markets didn't react strongly, but the potential for something bad to happen over the weekend was certainly there. Implementing the strategy outlined in those earlier articles, an investor would have taken a 10% position in the VIX ETF (NYSEARCA:VXX). Today, when the bad news hit the markets, the VXX would have partially hedged the portfolio. While the S&P 500 fell 0.74% today, the VXX was up 5.49%. The 10% position in the VXX almost hedged the entire other 90%. The 10% VXX would have added 0.54%, and the 90% S&P 500 would have lost 0.66%, so the portfolio would have only lost 0.12% today.

Had the investor used futures instead of the VXX, the portfolio would have shown a nice gain because the March VIX future was up 9%.

The interesting point about today's action is that the markets aren't picking up what bully Putin is laying down. While the Russian markets sold off extensively, the US markets were well-contained. More importantly, the VIX Index barely moved considering that there is a potential for war. The VIX went from 14 to 16, a nice 14.29% gain, but that is far below what one would expect from such a seemingly serious event. The VIX is still well below where it was when we started the year. The further-out VIX futures are essentially unchanged. Basically, the markets aren't fearing Putin... yet.

(click to enlarge)

(Source: Yahoo Finance)

The following is an article I wrote over the weekend as an example of how an investor could use the VIX ETFs to hedge a portfolio.

I recently wrote a few articles addressing the VIX Index and its associated ETFs. The conclusion was that the VIX ETFs do not track the VIX Index very well, and that the ETFs were best used in a "tactical" model that did not require holding them for extended periods of time. Because of the "EKG" nature of the VIX Index, it is best to buy the VIX ETFs once the VIX Index has returned to its "base level" which has recently been around 12. That simple model would have generated 3 trades last year and had a 100% success record.

(click to enlarge)

(Source: Yahoo Finance)

While the graph didn't make it below 12 on the last buy trade shown, the VIX did trade below 12 during 3 days of mid-January.

DateOpenHighLowClose
Jan 15, 201412.1512.4011.8112.28
Jan 14, 201412.8912.9011.9612.28
Jan 13, 201412.1813.6511.8213.28

The key is to buy the VIX ETF into weakness, and sell it into strength. To enhance the return, one could sell the VXX and buy the Short VIX Fund (NYSEARCA:SVXY) for the ride back down to the VIX Index's base level. Sounds easy, but nothing is ever that easy with the markets. These ETFs are extremely volatile and the windows to lock in gains is often extremely short.

Because I don't like "black box" models like I've outlined, I always like to add a subjective overlay to any model. The time to hold the VXX is when the VIX Index is near 12, but you can also see the potential for an exogenous event to spook the markets. Right now, the events in Ukraine present just that situation. While the markets haven't reacted yet, future events are unknown, and so now is the time one would want to buy insurance.

This may sound like "technical" analysis, but it is really fundamental analysis with a "technical" overlay. The key is to first identify periods when the "risk-off" trade is applicable, and then buy the VXX if it is close to 12, you don't just automatically buy the VXX at 12, even though, as demonstrated above, it has a pretty good track record. I will try to detail a "portfolio insurance" model for using the VXX in this and future articles. It is a combination of both fundamental and technical analysis that will provide buy and sell dates and levels. It is a tactical overlay for a strategic portfolio that attempts to enhance the returns of buy and hold portfolios by providing a vehicle to provide temporary insurance against sudden downturns in the market.

Because the VXX traded down in after-hours, I feel comfortable starting a model portfolio based upon this theory as if I bought on the close Friday. I thought of this trade Friday, when I saw the news on Ukraine, but am just now sitting down to write this article. As I write this, the S&P futures are down big, so I'm pretty sure starting the trade at Friday's close is going to give the portfolio a boost relative to if I had waited until tomorrow and written it during the day with real-time trade numbers. I will then write future articles every time a buy or sell is triggered.

DateSymbolPriceBuy/SellAmountShares
2/28/2014VXX$43.87Buy$100,0002279.462047

I will also report other statistics as well.

Gain/LossMax DrawdownPotential Gain

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Source: Don't Let Putin Scare You, Bully-Proof Your Portfolios With VIX ETFs

Additional disclosure: I may buy VXX tomorrow or sometime during this week. It is an Index ETF, so I doubt that my buy could influence an entire index.