Are You Prepared For The VIX Spike?

Are you afraid that the unprecedented seven-year bull market advance will soon come to an end?  Well, you are not alone.  With quantitative easing measures rapidly winding down, greater numbers of market professionals are leaning toward a bearish bias.  Add in the specter of rising interest rates and it becomes a question of how long can the bull market last with the heavily bearish macroeconomic picture.

The smart money is setting up to hedge their portfolios and actually profit from the potential sharp decline in the stock market.

Fortunately, there are two new ETF’s that will enable the average stock trader to hedge and profit like a professional.

Prior to explaining how you can use these new trading instruments, let’s take a brief historical look.

The U.S. stock market is an exciting and profitable place to invest.  Humbly launching, under a lower Manhattan Buttonwood tree, in the 1700’s,   It has grown and morphed into a global, cross-asset, financial behemoth.

All different types of financial instruments are now able to be accessed via the traditional stock exchanges.  Leading this beneficial charge is the growth of Exchange Traded Funds or ETFs.

Exchange Traded Funds have radically altered the landscape of the stock market.  These widely diversified tools allow stock investors to access markets and instruments never before available to those without specialized financial accounts.   The access provides active investors the ability to take action and profit from their ideas about what the future holds across a wide spectrum of geographical areas, commodities, stock indexes, bonds and futures.

This access is becoming wider all the time!

The $2.6 trillion ETF market is projected to grow to $5 trillion by 2020, according to a PricewaterhouseCoopers report entitled “ETF 2020: Preparing for a New Horizon”

Today, with the unprecedented seven consecutive year stock market advance, investors are becoming very nervous about the bull market continuing.  The bull market could easily last another several years or it could end tomorrow.

Smart investors are seeking ways to hedge their bull market portfolios over a variety of timeframes due to economic changes.

VIX chart

Many professional investors are expecting this market uncertainty to result in a volatility spike in the stock market.  Volatility is measured by an index known as the VIX.   While there are a variety of ETFs, future contracts, and options that investors can use to profit from the movements of the VIX, with symbols such as VXX, VIXS, VIXY, VXZ, and VIXM, several new exciting ETF’s are about to launch that are slated to better represent the index.

These new tools are designed to track the VIX index on both inversely and directly.   Here’s a brief primer on the VIX.

The VIX was initially utilized in 1993. It is designed on a concept credited to Professor Robert Whaley. The VIX consist of a weighted mix of prices across a wide variety of options on the S&P 500.

roberty whaley

As you know, options are priced on the expected volatility or price change over the next 30 days.

 An easy way to conceptualize options is to think of them as an insurance policy.  Insurance premiums are priced based on the likelihood of an adverse event occurring.  The greater the odds of the event, the higher the price for the premium.  At the same time, the lower the odds or expectation, the lower the price for the premium 

Applying this insurance policy idea to the VIX, the higher the index, the greater number of professional traders feel that stocks will take a downturn.   The lower the VIX, the fewer traders buying insurance in terms of options to protect against a pending downside.

Precisely stated, the number of the VIX represents the annualized expected percentage down move of the S&P 500 over the next 30 days. (If you are mathematically disposed, the VIX is calculated as the square root of the par variance swap rate for the next 30 days.)

The figure has ranged from as low as 9 to as high as 89 during the financial turmoil in 2008.

vix s&P

View it as the S&P 500 upside down. As the VIX moves higher, the S&P 500 moves lower. When the VIX moves lower, the S&P 500 generally travels higher. The VIX is called “the fear index” for a reason. The higher the fears in the market, the more traders hedge their positions with options, driving up the price of the options, therefore the price of the VIX.

Now that you understand what the VIX is, how can an investor put it to work?

As was stated earlier, there is a variety of VIX focused trading and investing instruments.  However, what has me most excited are two new ETF’s designed to reflect the VIX.

What’s very interesting about these ETFs is that are designed by the VIX creator himself, Dr. Robert Whaley.  This is very important since in the crowded ETF world, having such a strong pedigree will bring enough cache to the new funds to attract widespread interest.

Whaley’s company AccuShares is launching two new VIX ETF’s on Tuesday, May 19th.

 

The first one is appropriately named the Spot VIX Up Class (VXUP).  This ETF has the targeted goal of tracking the VIX over a one month time frame.  The second ETF from Whaley’s company is named Spot VIX Down Class (VXDN).  This ETF seeks to track the inverse performance of the VIX over a one-month time period.

VXDN

You see most ETFs are created to track spot indexes and commodities.  This is engineered by purchasing future contracts that represent the underlying product.  The issue is when these future contracts expire, the manager needs to purchase the next contract to keep the ETF tracking the underlying.  Each transaction is costly and futures are generally contango.  In finance speak this means that the further out in time that you go, the more expensive the contracts are.  This further adds to the cost of managing the ETF.

The professor has worked around this problem by holding cash and cash equivalents.   Each ETF is made up of an up asset class and a down asset class.  These assets are traded back and forth, by the manager, based on the decrease or increase in the spot price.

In the middle of each month, the 15th to be exact, the ETF underlying portfolio is calculated again.  What this means to traders is that every time you purchase one of these new ETFs, it’s a speculation on where the VIX will be on the 15th.

Clearly, if you expect volatility to increase between now and the 15th, you would purchase the VXUP, if you forecast a volatility decline, the VXDN would be appropriate.

While the contango risk and cost is minimize, these ETF’s are not cost free for the trader.  A management fee of approximately 90 basis points is accessed annually.  In addition, traders who buy Long VIX, there is what is called a tail risk insurance premium that is paid the Short VIX of 15 basis points per trading session.

I know this sounds unusual so here is the explanation.  The VIX is unlike a stock since it is close to guaranteed to move higher at some point in the future.  This means that eventually, longs will make money.  Therefore the shorts are truly getting the “short end” of the stick from the start.  In order to make the shorts take the trade, they need to be compensated.  The 15 basis points fee paid by the longs offsets the eventual nearly guaranteed drop in value.   Professor Whaley choose the 15 basis points since it’s the amount he believes is required for market participants to feel comfortable making a market.

Lastly, there is a monthly cash distribution on which any accrued interest will be taxed as ordinary income thus reported on form 1099.

How Can You Use These New VIX ETFs?

The new Accushare VIX ETF’s are expected to provide more precise following of the VIX index than the existing family of VIX ETFs and ETNs.  Traders can use the new VIX ETF to help create short tern hedges to protect bull market gains.  In addition, traders can use these new products to place short-term directional bets on the VIX index.

The Key Takeaway

The seven year bull market may be coming to a close soon.  Smart investors are finding ways to hedge and profit from the end of the bull stock market.   Volatility is certain to spike higher as the stock market eventually sells off.  This volatility is measured by the VIX index.  There are two new ETF’s that are about to launch that closely track the index.  One tracks the index directly while the other follows inversely.

These new ETF’s have a variety of costs associated with them and are only suitable for short term holding periods.