A Large Correction Coming? Ways To Profit On Volatility

by: Quad 7 Capital

Stocks have had strong gains for four months straight after dipping in November. However, there are some signs that this rally could be stalling. The Dow is now at 14,519 and the S&P 500 is at 1548. At the time of this writing the stock market is facing its worst week of 2013. With the Dow Jones ETF (NYSEARCA:DIA) is at 5 year highs at $144.89 and SPDR S&P500 ETF (NYSEARCA:SPY) at near its highs at $154.75, we have to question how we got here.

The economy has not really rebounded all that strongly. There are some bright spots, but the market seemingly has been propped up by the actions of central banks. First, in late summer of 2012, 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. 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 last year and another massive stimulus before the weekend. Then the Fed recently made a new announcement to accelerate its debt-buying program, to spend another $40 billion to $45 billion a month in balance sheet expansion to replace Operation Twist. This action has been excellent for stocks.

But the economic data in the U.S. is still rather weak. Today's jobs number reporting 88,000 added when analysts expected 200,000 was awful. Fears in Europe are also returning as their economies are contracting and investors are worried that the issues in Cyprus could spread in the eurozone. It seems that earnings estimates may be too high and these weak economic reports are the focus of investors. Given the weakness, volatility could return quickly, especially if we see a long overdue correction.

To take some protective action, 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 disappointing earnings, domestic debates that raise fear levels, or other international turmoil. These funds have performed terribly in 2012 and in 2013 as the market has seen record low volatility and extreme positive action. If this changes, expect the following funds to provide extreme short-term returns.

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 $20.57, and has a 52-week trading range of $19.56-$91.52 (please note this range does not account for shares reverse splitting).

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 $3.57 even after undergoing a reverse split. TVIX has a 52-week range of $3.29-$111.80 (note this range does not account for shares reverse splitting).

ProShares Ultra VIX Short-Term Fut ETF (UVXY): This is my favorite play when I expect short-term volatility 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 $7.75 and has a 52-week range of $7.15-$248.70. 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 for the last few months, volatility has been quite low. A few more pieces of bad news, starting with lackluster earnings, more economic contagion in Europe or failure in Washington to move on the debt 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. I think a short-term move to make in your portfolio if market panic ensures and stocks sell-off is by playing volatility funds and these are the ones that I recommend to trade.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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.

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