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ETF Periscope: The Velocity of Volatility

Posted on the 15 August 2011 by Phil's Stock World @philstockworld

ETF Periscope: The Velocity of Volatility

Auto racing is boring except when a car is going at least 172 miles per hour upside down.” –  Dave Barry

ETF Periscope: The Velocity of Volatility
If you happened to have had the good fortune to have taken the last week off for a peaceful summer retreat, sequestered away somewhere quiet and serene without proximity to newspapers or laptops, you might have been a little surprised upon your return to find out that the Dow Jones Industrial Average (DJIA) slipped 175 points over the course of last week’s five sessions.

You’d undoubtedly be even more surprised to see how it happened to arrive at that particular destination.

In fact, a whirlwind tour of the great roller coasters of the world surely would pale in excitement compared to the wild ride you could have experienced merely by monitoring closely the Dow’s series of mid-triple-digit moves that occurred throughout the last week.

Volatility ruled Wall Street, and a mere 1.5% drop on the week for both the Dow and the S&P 500 Index (SPX) hardly conveyed the concern and uncertainty reflected in both the national and international markets.

Fear has been, on the whole, trumping greed most soundly. That lack of balance is what market corrections are made of.

If anyone happens to be keeping score, the Dow now has dropped nearly 1,500 points in a little over three weeks. As of market close last Friday, the Dow stood at its lowest level in almost one year.

Purely in terms of volatility levels, the past week’s extreme market action has not been seen since 2008, when the whole financial market meltdown began in earnest.

And nobody can like the feeling of déjà vu that the current market action might evoke from that too-recent past.

But are such concerns actually warranted?

It is just possible they may be.

You can easily trace back the current downward trend to early July, when the whole EU sovereign debt crisis returned to the forefront of investors’ attention. Certainly, the cracks in the U.S. economy that have emerged in recent government reports, coupled with the incompetence of the legislators in D.C. as most recently evidenced by the U.S. ratings downgrade, seem to have served as a reminder that this is what a failed recovery might actually look like.

Yet it is the ongoing saga of the EU, first with Greece, Ireland and Portugal, then Italy, and now perhaps France, that may be giving intercontinental investors a reoccurring case of the heebie-jeebies. After all, even the remote chance of the EU dissolving due to insolvency is such a traumatic premise that the markets simply can’t help but to slide into panic mode upon even thin evidence that such an event could actually take place.

The current round of incestuous lending by the European Central Bank is a short-lived solution at best, as evidenced by the need of Greece to “return to the well” in little more than a year. And it has become evident that Greece is not necessarily the weakest link in the EU fence.

On Tuesday, second-quarter GDP data will be released for the euro zone. Good numbers can go a long way to calming the strong case of jitters emanating from the region. Weak numbers will goose the current downtrend, both in Europe and on Wall Street.

No matter what the results, however, volatility will continue to be the name of the game for now, and perhaps from here on out.

It is essential for investors to come to grips with the reality that big volatility swings will be part of the investment landscape, at least for the foreseeable future. It is and will remain a global economy, and regional problems are both inevitable and strongly magnified on the world stage.

So fasten your portfolios, there’s a good chance the velocity of volatility is about to increase.

In general, you can gain a strong read on the level of angst in the markets by observing the action of the VIX. The VIX, which is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, consists of a wide range of S&P 500 index options, and is rarely mentioned without being noted that it is commonly referred to as the “investor fear gauge”

When the VIX goes up, it indicates uncertainty, usually accompanied by a drop in the equity markets. Inversely, when the VIX goes down, the Dow tends to trend up.

Taking a look at the VIX action over the course of the year to date, one notices that from January until July, the VIX lived in the neighborhood of 15-25. Then, over the course of the last two weeks, the levels shot up to 48. As of last Friday, it came down a bit, landing at 36. It was still up 14% for the week.

You can take some of the fear out of these wild “mood swings” by utilizing the VIX as a hedging tool. That 14% upward move could serve rather nicely as “disaster insurance” to protect a bullish portfolio.

Of course, the thing about insurance is, nobody wants to pay the premium. Not, at least, until the insurance is needed.

Then, it seems like a brilliant idea.

Fortunately, is not difficult to keep the cost of your “insurance premiums” down to a reasonable level. One way to accomplish that is to use leverage, either via options or leveraged ETNs (exchange-traded notes).

VXX (iPath S&P 500 VIX Short-Term Futures ETN) is the most popular ETN by volume, while TVIX (VelocityShares Daily 2x VIX Short-Term Futures ETN) is a 2X leveraged ETN. Though both ETNs are derivatives based on the VIX, neither tracks the index precisely.

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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