ETF Expert

Praise the reduced threat of health-care intervention for Tuesday’s surge higher. Blame China’s focus on restricting credit for Wednesday’s dramatic move lower.

Here on Thursday, 1/21/10, it’s the uncertainty created by Obama’s proposed bank regulations that has caused extraordinary selling pressure for stock assets. For 3 consecutive trading days, then, we’ve seen the major U.S. benchmarks move up or down by 1%+.

There are several exchange-traded vehicles that a sophisticated trader may employ to hedge against volatile price swings in stocks. While they are not portfolio keepers, they can serve in a preservation capacity. They may even be particularly useful in a taxable account where… if you believe the market is merely bracing for a correction/pullback… these “ETNs” can help you avoid liquidating holdings with adverse tax consequences for selling.

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) as well as the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) track a basket of futures for the stock market’s “fear gauge,” the CBOE Volatility Index (VIX). The VIX generally rises when the S&P 500 falls, as investors become more fearful. Conversely, the VIX tends to drop when the S&P 500 moves decidedly higher.

If you purchase VXX, you expect volatility to rise over the next month. If you invest in VXZ, you’re expecting volatility to become an issue a few months out into the future.

This may be the biggest misunderstanding when it comes to using these ETNs. Think of the word “short-term” in the iPath S&P 500 VIX Short-Term Futures ETN (VXX). It is the riskier investment with more erratic price swings because it is focusing on the immediate month. This is why VXX is up more than 5% through mid-day, Thursday, as people seek protection against an imminent market pullback. (Click here for additional ways to deal with ETF portfolio risk.)

Although the iPath S&P 500 VIX Short-Term Futures ETN (VXX) is up 5% mid-day on Thursday, 1/21/10, if you believe a market correction is imminent, you haven’t missed your opportunity to hedge. The price on VXX is about the same that it was 5 days ago.

If you feel that we may be in for increased volatility several months out, or if you wish to protect against the possibility, the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) is a hedge with less erratic price movements. Sure, VXZ will usually gain if/when the market drops; however, the gains will be less pronounced on a daily basis… just as the losses will be less pronounced.

The chart below shows how… over the last 6 months… betting that a short-term 10%+ correction might be imminent led to serious losses for iPath S&P 500 VIX Short-Term Futures ETN (VXX). Conversely, you have more wiggle room with VXZ… because you are pushing the probability of a 10%+ correction or bear further out into the future. (And, of course, if you don’t have a bear or severe enough correction, these trading vehicles do lose money.)

If you’d like to learn more about ETF investing… then tune into “In the Money With Gary Gordon.” You can listen to the show “LIVE”, via podcast or on your iPod. If you’d like to subscribe to ETF Risk Alert, click here.

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