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ETF Periscope: Low-Level “Fear Gauge” Makes VXX A Sweet Pairs Partner

Posted on the 20 March 2012 by Phil's Stock World @philstockworld

“It’s not wise to violate rules until you know how to observe them.”T.S. Elliot

ETF Periscope:  Low-Level “Fear Gauge” Makes VXX A Sweet Pairs Partner
For the majority of 2012, the market has been acting like a fairly reasonable creature, as opposed to the nervous and jittery beast that dominated Wall Street for the second half of 2011.

Since December, when the European Central Bank finally came up with a big enough “bazooka”, in the form of its Long-Term Refinancing Operation (LTFO), to address the Eurozone banks liquidity crisis, investors have pivoted with rather surprising speed from risk-off to risk-on.

The result has been a strong and steady uptrend in the equity market, which has sent the key indexes soaring to heights not experienced since the financial crisis hit full force back in 2008.

In spite of the fact that the Dow Jones Industrial Average (DJIA) shed about 20 points on the final day of last week’s trading calendar, it is certainly worth noting that the Dow just finished a run of seven consecutive sessions that concluded in the black. For those who keep score of such streaks, it has been over a year since the Blue-Chip Index ran off that many winning sessions in a row.

Of greater significance perhaps is the fact that the benchmark Standard & Poor’s 500 Index (SPX) managed to remain above the psychologically significant 1,400 level, as it reflects a broader cross-section of the equity market compared to the far narrower DJIA.

Reflecting the high correlation of the European bourses with Wall Street, Europe’s equity market has also been seeing some of its best overall performance numbers in over eight months, when the fear of Greek contagion became the elephant–sized blip on the radar of concerned investors.

On Friday the SPX stayed above the 1,400 level it hit just last week, the first time since May 2008 it topped that lofty number. Meanwhile, European stocks hit their highest level since before the market’s slump in late July.

That investors are feeling more confident and less skittish at the moment can also be seen by a quick read of the VIX (Chicago Board Options Exchange Market Volatility Index), which is often referred to as the “fear gauge.” It continues to trade at the very bottom of its 12-month range, even hitting numbers that it hasn’t visited since 2007.

Some observers see this current round of investor complacency, as being reflected in the VIX, to be a sure sign that the market may be ripe for a correction and that the time for taking profits off the table may be close at hand.

However, the trend is inarguable, and how to play it remains the question.

As things currently stand, the mood on Wall Street seems to be, at least for the moment, robust enough to shake off the same stirrings and rumblings from both the EU and the domestic economy that, until the calendar flipped over to the New Year of 2012, would have sent sellers into panic and buyers off to the sidelines.

What the Periscope Sees

With the VIX remaining at a relative low point, it may be regarded as a reasonably priced portfolio hedge. At the same time, it may also be seen as the perfect match for a pairs trade, riding alongside your favorite Bullish play.

One example of such a trade might consist of using the VXX (iPath S&P 500 VIX Short-Term Futures ETN), which tracks the VIX near-term futures contracts, as a proxy for the volatility index, and pairing it with
XHB (SPDR Homebuilders ETF), which tracks the S&P Homebuilders Select Industry Index.

With a spate of housing data due to be reported this week, analysts are projecting some relatively positive numbers to emerge. It may finally be time for investors to consider adding some of this sector to their portfolio, if they haven’t already, particularly as there is a fair amount of headroom for the sector to travel.

One way to play this trade would be to go long both the XHB and the VXX. Another way to make the trade would be to buy call options for both the VXX and the XHB.

Two longs as a pairs trade? Sure.

What makes this so is the fact that the VIX generally goes up when the market dives, and vice versa.

ETF Periscope

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

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