Lately stocks have been moving sideways after strong gains for two months straight following central bank action to bolster equity markets. First the European Central Bank announced an unlimited short-term bond-buying program with some conditions, reinforcing its position to do all it can to save the euro. Then the German High Court upheld the decision to back the bailout fund with few reservations beyond reviewing any proposed increases to the bailout. Following this, Ben Bernanke and the U.S. Federal Reserve announced a massive third round of quantitative easing, aka QE3, consisting of buying $40 billion in mortgage assets monthly until unemployment improves. Even the Bank of Japan recently hopped on board the central bank stimulus train and announced its own round of easing. Now that the allure of central bank action has passed, earnings and economics reports are returning to the focus of investors. The most recent jobs report, which showed unemployment dipped to 7.8%, was weak overall, including the addition of only 114,000 jobs. This week's unemployment claims report for the week ending October 13, showed another 388,000 initial claims, much more than anticipated.
Many professionals believe earnings estimates are too high and will not be beat frequently this quarter. While the banks earnings have been relatively good, Thursday we saw major misses by both Google (GOOG) and Microsoft (MSFT). GOOG's earnings were far below estimates, coming in (excluding items) at $9.03 per share, down from $9.72 a share in the year-earlier period. MSFT reported earnings of 53 cents per share. Analysts had expected the company to report earnings of 56 cents a share on $16.42 billion in revenue, according to a consensus estimate from Thomson Reuters. In addition there is the looming fiscal cliff and a highly contentious election to consider in the U.S. in a few weeks. Thus traders may want to put on some bearish positions. Those who are bearish could consider selling stock, selling covered calls on their positions, shorting stocks or buying puts. While each of these approaches has its respective benefits and risks, in this article I want to highlight three volatility funds that could provide great short-term returns in the event of a market sell-off on continued disappointing earnings or international turmoil.
Ipath S&P 500 Short-Term VIX futures ETN (VXX): The Chicago Board Options Exchange Market Volatility Index or the VIX, is a popular measure of the implied volatility of S&P 500 market index. You may hear it often referred to as the fear gauge or the fear index. The VIX is a measure that is supposed to represent the market's expectation of stock market volatility over the next 30-day period. The VXX is a fund that is one of the better ways to track the VIX (which is not directly available to invest in) in my opinion. This investment seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 index at various points along the volatility forward curve. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract. VXX recently underwent a major one-for-four reverse split to increase share value. The fund has an annual expense ratio of 0.89%, is currently trading at $32.88, and has a 52-week trading range of $32.48-$198.04.
VelocityShares Daily 2x VIX ST ETN (TVIX): This is my least favorite, but still effective play on very short-term volatility. The return on this fund is linked to twice the daily performance of the S&P 500 VIX Short-Term Futures. It was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. The calculation of the VIX is based on prices of put and call options on the S&P 500 Index. This fund has a 1.65% expense ratio and currently trades at $1.26 and has a 52-week range of $1.25-$69.10.
For the last few months volatility has been quite low and a few pieces of bad news starting with continued lackluster earnings or more economic contagion in Europe could spark a sell-off. Consider picking up some units of these indexes or some in the money call options as short-term plays on anticipated volatility should you expect a sell-off. Do not however buy and hold these funds as the contango associated with volatility futures contracts eats into the share price over time. They are short-term plays only.
ProShares Ultra VIX Short-Term Fut ETF (UVXY): This is my favorite play when I expect short-term volatility to spike. The investment fund seeks to replicate (net of expenses) twice the return of the S&P 500 VIX Short-Term Futures index for a single day. The index measures the movements of a combination of VIX futures and is designed to track changes in the expectation for one month in the future. On average approximately 3.9 million units exchange hands daily. The fund has an expense ratio of 1.41%, currently trades at $25.63 and has a 52-week range of $25.04-$1567.80. This wide range has been a result of multiple reverse stock splits conducted by the fund's managers.
Bottom line: It's a lot easier to make the bear case than it is to make the bull case right now in my opinion. There are a lot of ways to prepare for potential short-term sell-offs including selling covered calls, buying puts, shorting stocks and stock indices, or just plain old selling equities to raise cash. While central bank action has bolstered markets, I believe earnings, trouble in Europe and the upcoming election will dictate the direction of the market. I think a short-term move to insure your portfolio against a sell-off by playing volatility is an approach to consider.
Disclaimer: I am not recommending investors to be bullish, bearish or neutral. This article is for informational purposes only and highlights funds one can consider in the event or anticipation of short-term volatility and bearishness. It is not a recommendation to buy or sell any of the aforementioned assets.