Does Volatility Really Matter?

May.11.12 | About: iPath S&P (VXX)

Why Volatility Matters

I often like to divulge the fact that I know nothing about stocks. My wife would probably maintain that I know nothing about interpersonal relationships either, but that's an altogether different premium article that perhaps explores the world of computerized dating companies. But just as it's often said that you don't need to be a genius to create progeny, you clearly needn't be cognitively equipped to be an investor in order to create profits.

In fact, I'm a terrible stock picker and my timing is usually horrible, as well. If I were to look at the immediate performance of most stocks that I purchased or sold, you might be justified in believing that I practiced "Buy high and sell low" strategies. As I look back over 30 years of investing, I'm humbled by the fact that on those rare occasions in the first 25 years that I alone was responsible for the selection and purchase of a stock, it frequently turned out to be the worst performing stock of the year. Nearly 25 years later, I still have nightmares about L.F. Rothschild.

The fact that I neither understand fundamentals, nor technical analyses is probably a factor in my lack of skills. Although I believe that have the requisite ability to understand the basics of such analyses, I'm just too lazy to really dedicate myself to mastering the concepts and their application.

Fortunately, for many years, I only rarely made such purchases, as I entrusted my broker with all decisions and he had full discretionary privileges in managing the account. He was a traditional buy and hold broker who did reasonably well compared to whatever index was the most favorable one to use when comparing quarterly results.

During those years, I was the perfect client. Although I was completely hands off, I tracked performance daily, maybe even twenty times a day once computers and software made that possible. What I silently noticed was that it seemed that whenever we sold a stock we had always taken a circuitous path to the final price, regardless of whether we were registering a capital gain or loss.

Eventually, I started to track the stocks in the portfolio more critically and began using spreadsheets to perform "what if" scenarios on the seemingly predictable ups and downs of each holding. No one really used the word "volatility," back then, although maybe the more classical way to refer to it was "beta." My broker did occasionally mention the "beta" of a stock, but always in a disparaging manner and as something to be avoided. With his untimely death I decided to take control of my portfolio and give a go of managing the inherent price fluctuations of my shares, with the spreadsheets always close by for guidance.

Despite the fact that I profess to know little to nothing about the basics of investing, I still have no problem asking unsuspecting people to pony up $200/month for a subscription to get my trading alerts. Presumably, such people know even less than I do.

As an inveterate covered call writer, I'm clearly a conservative kind of investor, but do recognize that occasionally you need to spice things up, as long as you can manage the risk. Whereas most of my holdings are fairly staid and mainstream, there are times that an investor needs to step outside of that comfort zone in order to protect those holdings that are under fire.

So much has been made lately of the risks associated with volatility investment vehicles and the very ridiculous idea of investing in derivatives of derivatives. You have the concept of volatility, as based on a statistical formula measuring deviation from an expected mean. Then you have futures contracts, ETFs based on varying length contracts, options on those ETFs, not to mention inverse related ETFs and their respective options.

The commotion all started barely two months ago when the Credit Suisse Short Term Volatility ETN (NASDAQ:TVIX) just tanked in price overnight. Everyone was aghast and up in arms. Apparently, Credit Suisse had stopped creating new shares, without informing anyone, and their product started trading like a closed end mutual fund, which is to say that logic was no longer part of the formula.

Proponents of the product and those that believed that the general public was, in fact, ill-prepared to invest in such products, pointed to the prospectus disclosures that the TVIX ETN was expected to have no value in the long term.

Imagine how Ron Paul would feel about that, or even how that would satisfy Dennis Gartman's need to invest in those things when dropped on your foot would actually hurt, like gold. Never mind that he recently brought the Risk On (NYSEARCA:ONN) - Risk Off (NYSEARCA:OFF) ETNs to the market place. Those must be made of very heavy pieces of paper.

But I do take some offense when I hear the constant barrage of "Talking Heads" saying that these products, especially the leveraged variety aren't appropriate for individual investors.

There's no need for "inferences" here. The clear message is that individual investors just don't understand the risks or, perhaps, aren't intelligent enough to manage the risks.

Look, you don't have to understand the physics behind gravity and its effect on an object's acceleration down a cliff to know that there are certain common sense rules.

Do I understand "volatility?"

No, but that doesn't mean that I can't consistently profit from the unknown. Morticians do it all the time. The Credit Suisse issue bought volatility back on my radar screen, as I had successfully traded the ProShares Volatility product (NYSEARCA:VIXY) more than a year ago.

After looking at the risk - reward of venturing back into the arena, I settled on the Barclays Short Term Volatility ETN (NYSEARCA:VXX) because it offered weekly options, whereas the ProShares offering did not.

(Click to enlarge)

Just look at the relative performance of the S&P 500 versus VXX for the past year. WHile the S&P has been largely unchanged during that observation period, VXX has presented many opportunities and outsized price movements.

As opposed to my recent articles on Green Mountain Coffee Roasters (NASDAQ:GMCR) and Silver (NYSEARCA:ZSL) and (NYSEARCA:AGQ), for which I presented more than a year of trade by trade data, I'm unable to do so for my recent foray into trading volatility, as I have only been doing it for approximately six weeks, yet the results are impressive.

As with the examples I just cited, the trading results do not rely on an upward move of stock prices. Rather, they rely on price movement that is agnostic with regard to direction.

As an example, despite the fact that I don't care for charts, take a look at the first three days of trading in VXX the week of May 7, 2012.

VXX and VXX May 11, 2012 $18 strike call option 3 Day Price swings
(Click to enlarge)

Now that's volatility. Best of all, it's the intra-day variety of volatility.

As an example of how this product can be traded, let's go back in time. See if you can remember the glorious days back on April 17, 2012, at around 11:12 AM, back when the Barclays Volatility ETN was trading at $17.99.

I remember that day? I sold $18 puts expiring that Friday. At the time, I already owned various share lots. I did so as result of having made outright share purchase shares at various prices. Of course, I had also sold calls on those positions. at varying strike prices, reflecting the varying purchase prices of the lots.

On that particular Friday, as it would turn out, despite thinking that the puts would expire, a Friday rally in the market caused shares to fall below $18 and I was "stuck" holding the shares for $18. In return, I received a $0.65 premium.

As luck would have it, on Monday, the market opened on a downbeat and VXX shares went up nicely, quite a bit above the $18 strike price that I had envisioned However, rather than selling $19 calls, I selected to sell the well within the money $18 calls because I could derive a greater premium, and still had the opportunity to close my position at a profit if shares fell in response to a market rebound. With the one week option variety, such a fall in share price of the in the money option would be countered with a nearly 1 to 1 drop in option price, as well, which is certainly advantageous if you're on the selling end.

Beyond that, selling in the money calls increases the likelihood of having your shares assigned, as it is often a good thing to not get overly wed to a position nor to amass too large of a position.

As it turned out, the opening premium was $1.11 and had I been more greedy and willing to risk not getting my price, could have received even more within 30 minutes. However, by 10:15 AM, a mere 45 minutes after the opening trade, the underlying VXX shares had already given up their large gain and fallen to $18. An individual trader could choose to take profits on their option sale and close out the share position as well, or simply close out the options and wait for another opportunity to sell calls, taking advantage of the likelihood of gyrating prices.

Of course, the more conservative speculator could simply wait out the end of the weekly option and record a weekly 6.2% gain The best part is the VXX shares ended up right where they started, at $18.

In my other referenced articles I went through an analysis of the ROI on shares. In this case, I'll provide some simple summary statistics and allow the reader to look at the detailed trades, if they choose.

At its peak, during the investing period in question, I owned or would be obligated to purchase a total of 7800 shares. The average share cost was approximately $19.35. Currently, at the close of trading May 9, 2012, shares were trading at $17.75.

Having lost 1400 shares to assignment at a very small profit on those shares, the remaining shares, if closed out would represent a loss of $10,240

In return, thus far, I've received approximately $12,700 in option premiums, with the opportunity to use the underlying shares as an annuity in the creation of even more income.

At the moment, the net profit of $2,500+ represents a 1.6% ROI. During the same period the S&P 500 is down nearly 3.8%

That's why volatility is so great. In this particular case, the volatility was represented in a "volatility" vehicle, but the same principle can apply to many stocks that trade during periods of volatility.

There will be plenty of more opportunities to come, if you missed this one. Even a conservative portfolio and a adversity to risk, can benefit from what appears to be a risky vehicle on its surface.

Don't fear the unknown. Just take precautions.

Disclosure: I am long VXX, GMCR.