With the World Economic Forum (WEF) scheduled to hold its annual meeting later this week, and the European Union (EUO) holding its first summit of the year on Jan. 30, the possibility of negative sentiment from one or both of these two major events could easily lead to a shift in direction for the market.
The WEF, held annually in Davos, Switzerland, gives world leaders and key financial and business experts a chance to share their personal vision of the macro-economy with the world. And it often seems like a place that creates a pull-no-punches venue.
This can be evidenced by remarks made by the current head of the International Monetary Fund, Christine Lagarde, who expressed the opinion that the world economy could experience a "1930s moment", which, for anyone who either forgot their history or never paid attention in class, was a time of alternating hyper-inflation, depression and general all-around financial chaos.
This is not the sort of comforting opinion that tends to sooth investor sentiment, and signals some trouble on the Top Gun Options radar. More along these lines, and January may see a shift in focus from generally positive 4Q earnings reports back to the doom-and-gloom, EU-centered scenarios that have roiled world markets over the past six months.
True, in terms of the equity market for 2011, so far so good. Last week saw a third straight week of victories by the major indexes. The Dow Jones Industrial Average (DJIA) was up a tidy 2.4% on the week, with Friday capping a string of four winning sessions in a row. Meanwhile, the S&P 500 Index (SPX) gained 2% on the week, placing it at a level not seen since late July of 2011. A third closely watched index, the Nasdaq Composite Index (COMP) ended up 2.7% as of market close on Friday.
How the VIX Faired
On Friday, the VIX (Chicago Board Options Exchange Market Volatility Index) ended the day at 18.28, dropping to the very bottom of its six-month trading average. For the first half of 2011, the VIX had established solid base-line support at around 15. As the awareness of the depth of the EU debt problem resurfaced on the radar screen of many investors, the VIX soared into the stratosphere of close to 50.
It is the previous level of support, around 15, combined with more than a triple-multiple of that number, around 50, that offers investors a strong risk-to-reward ratio to consider in using the VIX as a hedge.
While you can't trade the VIX directly, you can use one of several liquid ETFs that track the Volatility Index. One of the most popular and most liquid choices is VXZ (iPath S&P 500 VIX Mid-Term Futures ETN), which tracks VIX mid-term futures. As it tracks futures contracts on the VIX further out than the VXX ((iPath S&P 500 VIX Short-Term Futures ETN), it tends to have a slightly smoother curve, making it something that may not need to be tracked quite as closely as the tighter-wound VXX.
This makes VXZ a good choice for a slightly longer-term hedge, which may suit your portfolio if you are making Bullish options trades two or three months out.
Happy hunting and make sure you hedge.