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ETF Periscope: Pick the VIX as a Sweet EU Hedge

Posted on the 24 October 2011 by Phil's Stock World @philstockworld

Courtesy of Daniel Sckolnik, ETF Periscope

Pick the VIX as a Sweet EU Hedge

“There is no exception to the rule that every rule has an exception.”James Thurber

ETF Periscope: Pick the VIX as a Sweet EU Hedge
The Dow ended Friday with a breakout performance, one that sent it above the sideways trend that it has been immersed in for the majority of the last three months. Could this be the Bullish push required to keep the equity market in positive territory for the year, or will the news out of Europe this week swat the major indexes back down into the red?

The Dow Jones Industrial Average (DJIA) ended the week 1.4% higher at 11,808, making it the fourth week in a row that the blue-chip index has been in the black. The S&P 500 Index (SPX) is on its own little three-week run, landing at 1,238, giving the benchmark index a gain of slightly over 1%. The Nasdaq Composite Index (COMP), however, finished the week at 4,087, down a bit over 1%.

The thing about the Dow’s 267-point gain on Friday is that we have seen this act before.  Similar, or even larger, gains have occurred no less than seven times in the last ten weeks. The only thing these impressive upswings have accomplished, at least up until now, is to have kept the Dow from diving deeper than the 15% correction it has recently suffered.

However, what makes Friday’s surge somewhat different, at least from a technical perspective, is that the Dow has convincingly broken out of a stubborn sideways pattern that it has been in ever since late July’s dizzying downward spiral. The same is true of the S&P 500, though to a somewhat lesser extent.

In a normal market, this breakout would provide, at the very least, reason to consider purchase of some stocks that, from a fundamental POV, can be considered oversold, and may now seem quite attractive.

There is a caveat, however, one that should be acknowledged before anyone feels compelled to shove all his chips to the Bullish side of the gaming table: This is hardly a normal market.

What has recently given Wall Street investors a bad case of vertigo may be attributed largely to the uncertainty emanating from the whole European Union sovereign debt crisis.

Simply put, for every time a solution seems to be put forth by the principal players in the EU drama, including France, Germany and the European Central Bank, it seems a contradiction or denial emerges that puts into question the viability of the professed solution.

As of Sunday, France’s Sarkozy and Germany’s Merkel indicated in a joint press conference that they were “making progress” in their efforts to resolve the differences that have kept any solutions from being successfully implemented. In a nutshell, France wants to have the EU’s European Financial Stability Facility (EFSF) leverage its 440 billion euro fund to keep the debt crisis contained to Greece, and away from “contamination” of the rest of EU’s members. Germany, on the other hand, wants to limit leverage to a large degree.

It is worth noting that one of the main advocates of the whole “leverage thing” is Treasury Secretary Tim Geithner, who may have forgotten that heavy leveraging was a key cause of the 2008 economy smack-down. He has been something of a cheerleader for having the EFSF utilize more leverage to solve the EU problem, and with the U.S. having a strong vested interest in how the whole EU thing plays out, it will be interesting to see which side prevails on the issue.

Supposedly, some compromise will be worked out by Wednesday, when the next round of the EU summit talks occurs. Until then, Wall Street will be biting its collective fingernails.

What the Periscope Sees

As of Friday, the VIX (Chicago Board Options Exchange Market Volatility Index), widely referred to as the “fear gauge,” was at 31, which is on the low side of its recent ten-week range. (The VIX generally goes up as the equity market goes down, and vice-versa.) This makes it particularly attractive as a short-term hedge against any negative surprise that might emerge from across the Atlantic, as the VIX reacts sharply and quickly to bad news and uncertainty.

On the other hand, it responds less extremely to even the best news, making it quite useful as a Bearish hedge in situations such as this week, where the market can turn on a dime, or a euro, as the case may be.

You can use VXX (S&P 500 VIX Short-Term Futures ETN) as a way to play the VIX, although it doesn’t mirror it precisely. Like the VIX, VXX usually moves up as the equity market moves down, and goes down as equities tilt up.

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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