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ETF Periscope: Why BATS is a Black Swan Precursor and VIX a Strong Antidote

Posted on the 27 March 2012 by Phil's Stock World @philstockworld

“People who say they don’t care what people think are usually desperate to have people think they don’t care what people think.” –– George Carlin

ETF Periscope: Why BATS is a Black Swan Precursor and VIX a Strong Antidote
Way back in the day, oh, somewhere around May of 2010, a reputed “fat finger” leaned a bit too heavily on the sell button, and traders went all bug-eyed as they watched billions of dollars in market value evaporate into the void of cyberspace in what seemed like a heartbeat.

Much hullaballoo was made over the “flash-crash” issue at the time, and unnerved investors and enraged pundits demanded that some sort of system of safeguards be installed to assure that such a harrowing event would never be replicated.

Ultimately, existing precautions were deemed adequate, not much of note was changed, and Wall Street, as is pretty much the modus operandi of the beast, moved on to the next looming crisis.

But perhaps they moved on a bit too fast.

As of late, more “real world” style worries have dominated the market conversation, predominantly in the form of the Euro zone sovereign debt crisis and the relatively slow recovery of the U.S. economy.

However, for those who pay attention to such things, something happened last week that might be seen as a harbinger of a different set of problems, problems that are a near-cousin to the flash-crash of 2010.

On Friday, like the return of a bad dream or a not-missed old flame, the dangers of the electronic market reentered the fore, when BATS, the third largest equities exchange operator on the planet, acted like a light with a loose wire and a short circuit. A serious glitch on the exchange caused a trade in APPLE to sour, ending with trading in the uber-company to be temporarily brought to a halt.

As if that wasn’t enough for BATS to have a really bad day, the fact that it occurred on the very same day that BATS Global Markets Exchange, Inc. was making its own IPO debut surely made it so. Just for emphasis, BATS dived down, albeit briefly, to the low, low price of less than a penny.

All the trades that were impacted by the glitch were subsequently cancelled, and BATS ending up, pulling its IPO offering off the market, at least for the time being.

One should likely not be surprised by the fact that such a thing occurred; rather, that it doesn’t occur with far greater frequency. And if the possibility remains that more such “glitches” will follow in the not-so-distant future, the chance also remains that the untangling of the botched trades may become more problematic the next time a similar event occurs.

Recently, there has been a lot of discussion in the financial press as to the viability of the VIX as a reasonable hedge against a downturn in the market. The VIX, known, though not necessarily affectionately, as the “fear gauge,” generally goes up as the market goes down and vice-versa. Appearing on the radar of an increased number of investors, the VIX has recently been trading at low levels not seen since just prior to the crash of 2007-08. This is generally accepted as an indication that a high degree of fear has been extracted from the market, at least for now. With both the Dow Jones Industrial Average (DJIA) and the S&P 500 Index flirting with ’08 highs, this lack of fear may be somewhat understandable.

Whether you buy into this fearless paradigm or not, what remains true is that the best time to buy insurance is when it is at a discount and a low VIX price represents one version of that insurance price break, though hardly the only one.

However, what makes the VIX worthy of serious consideration right now is not merely the low price it currently finds itself at. Rather, it is the nature of both the VIX itself  and the market in general.

The VIX is an explosive hedge, meaning that it reacts in an amplified fashion in regard to the extremity of a downside move in equities. If the market dives sharply, a quick glance at it the VIX chart reveals how fast and how far the fear gauge moves, making it a particularly valuable “Black Swan” type of hedge.

As for the market in general, virtually all trading volume is run through exchanges electronically; coupled with the fact that the majority of trades are now high frequency trades, both fast and furious, the recipe for mischievous glitches appearing and impacting the market will certainly rise.

Consider the VIX as one way to make a protective play against unruly machines.

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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