ETF to hedge against portfolio risk: VXX

Posted Jul 30th 2009 4:20PM by Mitch Tuchman

All of a sudden, investors don't seem to have a care in the world. The market is going up and up, and complacency has set in. One way investors measure this complacency is through an index called the "VIX." VIX measures the implied volatility of a basket of options on the S&P 500 index. The more investors are willing to pay for puts and calls, the more there is an implication that they are "nervous."

If you are a contrarian investor, the way you read the VIX is: 1) if you buy stocks now you are moving with the momentum of the market; and 2) the market could get really "choppy" soon, and 3) if you wait patiently to buy stocks after fear has returned to the market, you will likely enjoy a substantial gain when volatility returns to the market.

One way to buy the "level of fear" is through an Exchange-Traded Fund (ETF) called the iPath S&P 500 VIX Short-Term Futures (NYSE: VXX). This tradable volatility fund anticipates future moves in VIX which can neither be bought nor sold, since it is an index. Implied volatilities have not seen these "all is well with the world" days of early September 2008. VIX has recently been at its most complacent extremes.

When the market was crashing earlier this year, for example, VXX was trading up to 120. Today, its been below 60, showing the relative complacency of investors as stocks move up. But what if we have a couple bad trading days? What if the S&P goes back below 900? The VIX is going to go up as people panic, and VXX will trade up with it.

So use this great ETF as a way to hedge all the money you are hopefully making in the stock market.

Mitch Tuchman founded MarketRiders, an investment website teaching individuals how to save on fees and be their own investment advisor using low cost ETFs and asset allocation.

Tags: etf, investment advice, mutual funds

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Reader Comments (Page 1 of 1)

7-31-2009 @ 3:23AM

Uli said...

Readers be aware, VXX is ETN, not ETF. Was it due negligence or ignorance, difference between these two is big enough that author (or editors) should have corrected it.