A Rare Opportunity To Profit From Volatility

May.20.14 | About: iPath S&P (VXX)

Summary

The market has been consolidating around all-time highs and Fed has been curtailing its program so many investors are seeking a way to hedge against an imminent correction.

Selling part of the portfolio or buying put options have both been very damaging strategies during the whole 5-year bull market.

The current value of VIX and the time remaining till the expiration of its June futures offer a very rare opportunity to profit from a spike in volatility.

This year the market has recorded new all-time highs and has been consolidating around them for almost 3 months, which is a very healthy technical behavior. Nevertheless, thanks to the record levels and the imminent elimination of Fed's support, many investors have started to feel nervous and are looking for a way to mitigate their potential losses from an imminent correction.

I have described in detail in a previous article why I believe the market will continue to record new all-time highs for many years so I suggest that investors view any coming correction as temporary instead of a prolonged bear market. Very briefly, history has taught us that the S&P (NYSEARCA:SPY) and Dow Jones (NYSEARCA:DIA) trade in a range for 10-20 years and then always break to new highs without ever looking back thanks to the technological progress. The market has traded in a confined zone since 1997 and has only recently broken above this zone so it is likely that we are heading for the next level. Therefore, the protection the investors are seeking should only have a temporary character.

The first obvious way to hedge would be to sell a part of their portfolio. However, whoever has attempted to do so in this 5-year bull market has greatly regretted it and has not been given a single chance to buy again at the same price. Consequently, they have either missed the train or they were forced to repurchase their shares at a higher price, thus underperforming the market. Given the long-term perspective of the market, I don't recommend selling a stock, unless it has become overvalued relative to its earnings, in which case selling or switching to another stock is recommended.

Another way to minimize one's losses from a market correction is to purchase put options of one's stocks or a market index e.g. S&P. However, this hedging method requires excellent timing skills, otherwise the time value of the options is very expensive. Most of the options expire worthless so they usually subtract value from a portfolio and their cost can offset or even exceed the amount of dividends an investor receives. Again, whoever has bought put options to hedge in this 5-year bull market has greatly regretted it unless he/she possessed unique timing skills.

Finally, another way to reduce the losses or even profit from an imminent correction is to buy futures of VIX. In most cases, this strategy loses a great amount of money due to the pronounced contango structure of the VIX futures (prompt months are much cheaper than future months). To be sure, a well-known VIX ETF (NYSEARCA:VXX) has lost 50% of its value in a year and 99.3% of its value in 5 years. As it is evident from this performance, rolling the futures for many months does not leave any room for profit.

However, at the moment, there is a rare opportunity to profit from buying VIX futures. The spot volatility is 12.4, just above the 5-year low of 11.5, while the June future closed yesterday at 14.35. Even more importantly, there are 4 full weeks till the expiration of the June future (June 17th), which is a long enough period for a spike in volatility to occur. To be sure, despite the tremendous 5-year bull market, there has hardly been any month in which the volatility did not spike above 14. Currently, near all-time highs, this is even more likely, as any sell-off reinforces itself to an extent.

If the spot rises to about 14, the VIX June future will rise above 15, depending on the time remaining till its expiration, thus yielding a profit of about $1000 for each contract purchased. Each contract currently has an underlying value of $14,350 but the margin required is much less (around $2000) so the yield is excessive.

For conservative investors I recommend closing the futures with a profit of about $500 per contract but the other investors can expect to gain about $1000 per contract. It should be mentioned that it is not a sure profit, otherwise it wouldn't be so great. However, as I have been observing the volatility index for years, the current combination of the volatility price and the time remaining till the expiration date represents a rare opportunity in terms of risk to reward.

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.