Two ETFs to Play Market Volatility

 |  Includes: VXX, XXV
by: Wealth Daily
By Steve Christ

Landing with all the force of a feather, Quantitative Easing (QE) 1.5 might as well have been QE Nothing. A day after being announced, the Fed's latest attempt to goose the economy sent the markets into a tailspin as the Dow dropped 265 points Wednesday.

And for those of you scoring at home, the decliners led advancers by the magical ratio of 9 to 1, signaling a major reversal is at hand.

From the relatively placid days of July, market volatility made a gigantic comeback as the dollar jumped, Treasury yields plummeted and the VIX Indicator shot up by 14%.

But as any trader will tell you, it is at the exact moment the markets become complacent that they take one in the ear. After all, the last time the VIX had fallen this low (21.36) was May 3, just three days before the infamous "flash crash". In the aftermath of that gut-wrenching plunge, the VIX doubled in the span of just a few days.

That's one of the reasons why every trader on Wall Street keeps an eye on the VIX as they speculate on the market's next move. More often than not, it is the action in the VIX that signals major market tops and bottoms. That's because the VIX is one of the so-called contrarian indicators. That is, it tells you whether or not the markets have reached an extreme level of sentiment - either bullish or bearish.

If so, that tends to be a sure sign the markets are about to stage a reversal. Because let's face it, "the crowd" hardly ever gets it right. So, the smart money simply uses the VIX indicator as a sign to bet against them all.

The VIX Indicator Explained

Developed by the Chicago Board Options Exchange in 1993, the CBOE Volatility Index (Chicago Options: ^VIX) is one of the Street's most widely accepted methods of gauging stock market volatility. Using short-term near-the-money call and put options, the index measures the implied volatility of S&P 500 index options over the next 30 day period.

But because it is basically a derivative of a derivative, it acts more like a market thermometer than anything else. And like a thermometer, there are specific numbers that tell the market's story. A level below 20 is generally considered to be bearish, indicating that investors have become overly complacent. Meanwhile, a reading of greater than 30 implies a high level of investor fear, which is bullish from a contrarian point of view.

In fact, the old saying with the VIX is, "When the VIX is high, it's time to buy." That's because when volatility is high and rising, it means "the herd" is stampeding to the exits, leaving bargains for money-making traders. That's why successful technical analysts often rely on the VIX indicator to assess whether or not the current market sentiment is either excessively bullish or bearish in order to plot their next move.

How to Play Market Volatility

But it's not just a reading of "under 20" or "over 30" that works with the VIX. That's a bit too simple.

On top of those levels, smart traders also add the price movement within the Bollinger Bands into the mix. Of late, that has been one of the key tells in predicting the market action.

So what are Bollinger Bands you ask?... My pal and super-trader Ian Copper explains them this way:

Bollinger Bands are a popular technical indicator for traders to determine overbought and oversold conditions. In a range-bound market, for example, it works even better as prices travel between two "rubber bands," or like balls bouncing off the walls of a racquetball game.

For instance, in the VIX chart below you can actually see these "rubber bands" in action... [click to enlarge]

vixClick to enlarge

Check it out: As the VIX trades, volatility rises or falls as it bounces off of the upper or lower bands. It's these extremes that have marked the major market turning points from a contrarian perspective.

So as the summer relief rally begins to fade, the VIX is back in the headlines. That's because as months go, September and October tend to be rocky ones for the stock market.

In fact, historically, September has been the worst month of all time for stocks, while October is remembered as the month of epic crashes.

That likely means more market volatility in the months ahead - not less.

One way to play these market moves is by trading between these two exchange traded funds (ETFs) that Ian recommended to readers a few weeks ago.

  • Go Long the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) as the VIX falls to the bottom of the bollinger bands. This ETF rises as broader markets top and begin to fall.

  • Go Long the Barclays Inverse S&P 500 VIX Short-Term Futures ETN (NYSE: XXV) as the VIX rises to the top of the bollinger bands. This ETF rises as broader markets bottom and begin to head higher.

These and other winning options strategies can help you put fear and greed in their place, earning you big profits as you trade the extremes in market sentiment.

After all, when Ben Bernanke admits the economic outlook is "unusually uncertain", you can bet that market volatility is not that far behind.