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Without a doubt, the past 2 months have been kind to investors (well, investors who are long). Europe has been relatively calm, and economic data in the United States has been, for the most part, decent. These twin forces have combined to let the market log its best start to a year since 1991. As of the close of trading on Friday, March 2, the S&P 500 (NYSEARCA:SPY) is up nearly 9% year-to-date. The Dow (NYSEARCA:DIA) is up 6.2%, and the NASDAQ (NASDAQ:ONEQ), by virtue of having Apple (NASDAQ:AAPL), is up over 14%.


We have been bullish for some time on American equities, for we believe that the European situation will be resolved and that the American economy will continue to prove its resilience. That being said, we are growing concerned with the level of complacency in the market, as measured by the CBOE Volatility Index.

It is important to remember that volatility is not necessarily a bearish thing. Volatility measures price swings, which can happen in either direction. And the VIX measures the price of both call and put options. However, over the years it has come to be seen as the market's "fear index". As such, the VIX is now used to gauge the fear/bearishness of the market, even if volatility itself is not a bearish thing.

Over the past 5 years, we have experienced unprecedented volatility. The financial crisis and now the European debt crisis have cause enormous swings in the market. Ironically, the S&P 500 is down just 1.26% over the last 5 years.

With volatility, it is important to remember that the investors will always be willing to pay something for the protection that options grant them. The VIX has fallen nearly 25% year-to-date, and we think now is a good time to get in. The VIX currently stands at 17.29. Though this is much higher than the index's 5-year low of 12.07, achieved in April 2007, that distinction shows just how complacent the markets were in 2007. Someone who bought volatility at that point in time and sold it in October 2008 could have returns of up to 555%.

Before we explain how to invest in volatility, we must provide a note of caution. Volatility is an amplified bet, even when unleveraged products are used to invest in it. As such, an investors should not put a majority of assets into volatility, expecting to cash in on a day the market falls. Should a rally occur, volatility may very well plunge. It is better to think of this trade as a short-term hedge. Should the markets fall on some sort of black swan event, or negative developments from Europe, volatility will soar, and a prudent investor can cash out at that point, using the profits they have earned from this hedge to buy stock in companies they like at discounted prices.

So what is the best way to buy volatility? It is important to remember that the VIX itself cannot be bought. But as always, exchange-traded products are the answer. For years, retail investors could not buy volatility, as it was simply out of reach. But with the advent of ETN's, any investor can now purchase volatility. There are several various ETN's available to trade and invest in volatility, from both the long and short side, as well as leveraged and unleveraged products (it is important to keep in mind that volatility itself is leveraged, at least relative to the markets).

Perhaps the most popular volatility ETN is the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). It maintains a constant rolling position in one and two-month volatility, rolling over its allocation from one month to the next on a daily basis. Over the past year, this ETN has been the one that has most closely mirrored the actual VIX itself.

With volatility ETN's, it is CRUCIAL to remember the effects of contango and backwardation. In essence, contango occurs when the price of a futures contract is trading above the expected spot price at maturity, and backwardation occurs when the price of a futures contract is trading below the expected spot price at maturity.. When it comes to volatility, contango means that if investors expect volatility to rise in the long-term, the price of long-dated VIX contracts will be higher than for the price of short-term ones. And backwardation is the opposite of that. For those who wish to learn more about the structuring of these ETN's, iPath has a great explanation.

These trades are not meant for the long-term. Rather, they should be used as short, and possibly medium-term hedges against a possible decline in the market. Before investing, investors must define the threshold at which they want to exit, from both the upside and the downside. Over the long-term, many of the volatility ETN's diverge from the VIX itself, and for the moment, simply buying and holding them in perpetuity is not a wise investment.

That being said, with volatility at such a low point, we think that now could be a good time to invest in it to hedge against a potential pullback in the markets. There are several products available to invest in it.

iPath S&P 500 VIX Short-Term Futures ETN

This ETN invests in one and two-month forward contracts. It is unleveraged and is the most liquid of all the volatility ETN's. If we had to choose but one ETN to invest in volatility, it would be this one. The potential for gains is large, and the downside is, in our opinion, fairly well-defined.

As the markets spasmed in the summer of 2011, volatility skyrocketed, taking this fund up right alongside it. The chart above also highlights the importance of viewing this as a short-term investment. This ETN went back down just as easily as it went up. Granted, it was over a longer time frame, but in the short-term (which this trade is all about) the ETN did exceptionally well. Furthermore, as noted above, it tracks the VIX fairly closely. However, it is key to note that there is no ETN that can track the VIX precisely. That is an inefficiency that the market has yet to correct.

iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)

This ETN is very similar to the one described above, except it invests in medium-term VIX contracts. Here, the volatility contracts are in a four to seven month time frame, as opposed to the one and two month time frame. Like the short-term ETN, they are rolled over daily. The longer time frame in this ETN means that it more closely mirrors the S&P 500. Over the past year, the ETN has fallen about 2.5%, as the S&P 500 has risen 3.67%.


This ETN is less "amplified" than the short-term ETN described above. It rallied less than the short-term ETN in the summer of 2011, but it dropped less as well. For investors and traders who are looking for a calmer way to gain exposure to volatility, this could be a good way to do so.

iPath S&P 500 Dynamic VIX ETN (NYSEARCA:XVZ)

The third and final ETN we would like to present is the iPath S&P 500 Dynamic VIX ETN, which in essence, is a combination of the previous two ETN's. This note dynamically allocates between short-term and medium-term contracts by monitoring the steepness of the volatility curve. As a result, it currently has a 70% long position in medium-term contracts, and a 30% short position in short-term volatility contracts. The long/short nature of this ETN makes it act a bit differently than the other 2 ETN's. By allocating between a long and short position, this ETN not only allocates exposure to volatility, but attempts to generate alpha by exploiting the inefficiencies of the volatility market as well. And since its inception, it is a strategy that has worked.


Since the middle of August 2011, this ETN has returned over 5%, as the S&P 500 returned over 20%. The combination of volatility and inefficiency exploitation, in our opinion, makes this ETN an interesting choice for investors who not only want to gain exposure to volatility but also believe that there is a disconnect between short and medium-term volatility.

Conclusions

We remain bullish on the stock market, and believe that as Europe resolves its debt crisis, and the American economy continues its slow, but steady recover, the markets will rise. That being said, we think the run up that the last 2 months have delivered means that it is time to consider hedging those gains with an investment in volatility. We think that the downside is limited, as the VIX is trading at depressed levels, and that the upside potential is good. Should investors realize profits form this trade, they can then use those profits to add to or initiate positions in companies that are fundamentally sound, but have been sold off alongside the broader markets.

Disclosure: I am long AAPL, DIA.