How To Hedge A Short-Term Volatility ETN

| About: iPath S&P (VXX)

In these turbulent markets, derisking your portfolio is more important than ever. At Helix Investment Management, we invest for the long term, choosing stocks that will do well over the course of several years, not days.

Companies such as Intuit (NASDAQ:INTU), Tiffany's (NYSE:TIF), and Broadcom (BRCM) may not all outperform the market each day, but over a long time horizon they will. While we may invest for the long term, we are certainly not immune to the daily vagaries of the market. But rather than simply let the market control us, we control it through the use of hedging. We would like to bring this hedge and its benefits to our reader's attention.

The internet has revolutionized investing, letting investors react to and trade on virtually any piece of news. This has led to an unprecedented rise in volatility. While volatility itself is present in both strong and weak markets, lately it has manifested itself much more in weak markets, much like the ones we have seen for most of 2011. We have chosen to hedge the market using precisely that, volatility.

Until recently, volatility has been an investment out of reach to the average investor. But as with many things, the rise of ETFs and ETNs have opened the doors to this market. We invest in volatility through the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), an ETN issued by Barclays designed to track an index of 1 and 2 month forward VIX contracts. The fund maintains a daily rolling position in these contracts, changing its composition daily.

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Before we continue, we must stress that this ETN cannot be simply bought and held. The The fundamentals of this ETN, as well as the effects of contango (where the price of longer dated futures on the VIX are higher than short-term futures) and backwardation (where the price of longer date futures on the VIX are lower than short-term futures), mean that its usefulness fades the longer you hold it. With this ETN, you must trade in and out of it for it to be effective. Simply buying and holding it for an indefinite period of time is a surefire way to lose money. But trading in and out of this ETN is acceptable.

We invest in this ETN to shelter our portfolio from market storms, and in effect, have the chance to buy stock with free money. This strategy is dependent on several factors, which we discuss below.

  1. Outsized moves in the iPath S&P 500 VIX Short-Term Futures ETN: Volatility does not move inverse to the market in the traditional sense. For investors looking to simply hedge their exposure with traditional inverse ETF's, there are a number of products available, such as the ProShares Short S&P 500 (NYSEARCA:SH). Volatility usually has an outsized move relative to the market.

    On Wednesday's huge rally, the S&P 500 soared 4.33%. Yet the iPath ETN fell 8.87%. During bullish periods in the market, such as Wednesday, this should not matter, for even if volatility fell more than the market, its drop was mitigated by the fact that it is a small percentage of our overall portfolio, something that is crucial.

  2. Proportional exposure: Given the fact that the moves in this ETN are amplified relative to the market, it is imperative to ensure that any losses in this ETN do not overwhelm the gains in the rest of the portfolio. This strategy is useless as a hedge if on days the market moves higher you end up losing money by investing too much in volatility.

    Therefore, we never invest more than 5% of assets in this ETN, thus ensuring that we are able to make money on days the market rises. Even in bullish markets investors wish to protect their portfolios, thus ensuring a continued demand for VIX futures contracts.

  3. The concept of "pairing": We think of this trade as a pair trade, where this ETN is paired with the rest of our long positions. While we do trade in and out of our positions from time to time, doing so constantly would be inefficient. We invest in stocks for the long-term, and always look for opportunities to add to or initiate positions in companies we like. This ETN gives us the opportunity to do so.

    On days when the market is down, this ETN rises, and amplified by the powers of volatility, generates profits for us. We then sell the ETN, booking the profits and investing those profits in companies we like. Even though the rests of our stocks may have declined that day, we have bough what is in effect, free stock, thus offsetting the decline in the share price.

    It is true that on bullish days like Wednesday, even though our portfolio gained in value, it underperformed the major indices, having been dragged down by this ETN. But had Wednesday been a bearish day for the stock market, we would have outperformed, thanks to the rise in volatility. Such is the nature of hedging. The gains of a hedged portfolio are almost never as large as the gains of an unhedged portfolio. But then again, neither are the losses. We are willing to sacrifice these potential gains for peace of mind.

Investing in the iPath S&P 500 VIX Short-Term Futures ETN can reduce the volatility of your portfolio by, ironically, investing in volatility. We would like to once again remind readers that simply holding this ETN over the long run is essentially useless. Since its inception, it has lost over 90% of its value.

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And yet, holding this ETN over the short run can produce enormous profits. Over the past 6 months, it has done just the opposite, rising over 90% in value. While there is nothing wrong with always being long this ETN, it is imperative to trade in and out of it.

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Volatility is a great hedge if used correctly. We believe we have found a proper way of hedging our portfolio. By allocating a relatively small portion of our portfolio to volatility, we are able to channel profits from it into our other positions on down days, while insulating them from losses in volatility on days when the market rallies. We recommend readers examine this strategy to see how if fits into their investment strategies and if it is a good fit for them.

Disclosure: I am long VXX, BRCM, INTU, TIF.