Volatility Index: Why This VIX ETF Should Be On Your Radar (VXX, VIXY, TVIX, XIV, VXZ)

David Gillie: In the world of market volatility, what goes down, must come up. And the most likely time for that to happen is when the bulls and bears are sleepily resting on their laurels. Or, as it’s called on the Volatility Index (.VIX), “Complacency”. In the past, the average investor had no way to get exposure to the Volatility Index—which was reserved for the pit bulls in Chicago. Now with a plethora of ETFs and ETNs available, average investors have the ability to trade volatility, commodities and other market elements.

iPath S&P500 Short Term Futures (NYSEARCA:VXX) is an ETN for average investors to capitalize on the Volatility Index.

WOW! Why would anybody want to buy an ETF with all those negative performance numbers? The answer to that question is the price range. From its low to high, it nearly tripled. But this ETF (actually an ETN) moves fast. For anybody who’s ever been blindsided by a sell-off, you know that the price goes down much faster than it goes up. Because the Volatility Index is a close inverse correlation to the equities market (S&P500), VXX goes up much faster than it goes down. For this reason, you have to make your move before the market makes its move. The market is currently overbought and prime for a pullback.

To better understand volatility, let’s look at the S&P500 Volatility Index (.VIX) before we get to the chart of (NYSEARCA:VXX).

There are two generally recognized significant levels of the VIX: 30, which above that is considered “Fear” in the market, and 20, which below that is considered “Complacency” in the market. Much of the 2nd half of 2011 was in extreme levels of fear of the European Debt Crisis, our own (Congress) inability to adjust the debt ceiling in a reasonable fashion and possibilities of sinking back into a global recession. Much of that market anxiety has calmed, for now.

We see that the VIX has bounced off the 20 level twice, but this 2nd bounce was weaker than the first—almost too calm. If we look back to when the VIX was sub-20, we’ll remember that QE2 was still in effect and basically flooding the market with “free” money. That is not the case now and volume has been very light. More like a melt-up than a true rally in December and January.

I’m not going to go all Chicken Little and scream “The sky is falling”. I’m just saying we are due for a pull back—a healthy function of the market.

A prudent move for hedging your portfolio in anticipation of a pullback is buying VXX. (Or buying options on VXX if that’s your methodology)

Two of our indicators (RSI and Stochastic) are showing this position skipping along the bottom. The important indicator is the Money Flow Index (MFI) at the top of the chart. Smart money has already begun flowing into this position. Additionally, the MACD at the bottom of the chart is just about to have a bullish crossover. Although still low, we are seeing a slight increase in volume.

Unfortunately, VXX doesn’t have an exact correlation to the VIX. But we can establish some close correlation of the important price levels.

VIX 20 = VXX 30 (approx)
VIX 30 = VXX 50 (approx)

VXX below 30 would be a prudent position to take for hedging your portfolio. As the VIX tends to move very rapidly, usually the extent of its move in a week or so, setting your sell limit at the time of purchase would be a good idea. A sell trigger at $48 would capture the move of the VIX going almost to 30. It is unlikely for the VIX to go into extreme levels of fear with recent US economic data showing small steps of improvement and a certain degree of numbness to headlines out of Europe. If you want to be a little more conservative on your sell trigger you could increase the probability of a hit at $46. That’s still better than a 50% move off of $30.

Today the market looks to be stalling on low volume. Should we get a little spike on enthusiasm (or the Algo) in the next day or so, it could put VXX in our sub $30 price range.  “Hedge to avoid the ledge” as a great trader friend often says.

Related: ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY),  VelocityShares Daily 2x VIX ST ETN (NYSEARCA:TVIX),  iPath S&P 500 VIX  Short-Term Futures ETN (NYSEARCA:VXX), iPath S&P 500 VIX Mid-Term  Futures ETN (NYSEARCA:VXZ), VelocityShares Daily Inverse VIX (NYSEARCA:XIV).

Written By David Gillie For The ETF Digest

ETF Digest writes a subscription newsletter focused on technical analysis of exchange-traded funds.  ETF Digest was founded in 2001 and was among the very first to see the  need for a publication that provided individual investors with  information and advice on ETF investing.  Even if you’re not a fan of  chart analysis, ETF Digest provides insight and commentary into which  global markets are “working” and why.

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