Opportunities In Volatility Near Historic Lows?

By Cory Mitchell | Updated March 20, 2013 AAA

The CBOE Volatility Index, known as the VIX, hit its lowest level since 2006 on March 14. The low at 11.05 on the index coincided with a high on the S&P 500 at 1563.62 on the morning of March 15. The VIX and the S&P 500 typically move in opposite directions, with the VIX falling during bullish times for stocks, and rising when stocks fall. So with volatility near historic levels - showing investors are even more complacent with this rally than they were at the 2007 peak - is there an opportunity to "buy volatility?" It would seem so, as risk is near minimal, or at least was.

As of the March 19 close, the S&P 500 was off the recent high by about 1%. The VIX Index jumped about 30% over the same few days, to close at 14.39. Volatility/VIX based ETFs showed a more subdued jump and, therefore, may present an easily accessible alternative to VIX futures contracts for many traders. Here's how the VIX index and its related ETFs stack up.

SEE: Volatility Index Uncovers Market Bottoms

The Volatility Index has been declining over the last year and a half as the S&P 500 has been in an uptrend. The recent low at 11.05 is likely strong support, and a move much below this is unlikely. The low in 2006 was 9.39, but I believe that level is out of reach in the current environment. The 30% jump to 14.39 on such small gyrations in the S&P 500 over the last few days shows risk is on traders' minds and they are using the VIX to hedge against a potential market decline.

VIX speculate on market downturn

The iPath S&P 500 VIX Short-Term ETN (ARCA:VXX) is one of easiest ways to access volatility, if you are a stock/ETF trader. Over the long term it has been decimated, trading at a fraction of what it was even a couple years ago; therefore, this is not an investment. It is traded generally exclusively to hedge short-term stock positions or to speculate on a short-term rise or fall in volatility.

Since approximately mid-February there has been a marked increase in volume, with several sessions nearing the 100 million shares level. While this ETF has continued to decline, the recent low at 20.41 amid high volume could indicate a short-term bottom. Entering near current levels and using the recent low as a stop, controls the risk and provides ample upside if you believe the stock market will decline.

It may be too early to tell if the market is about to decline, though. Trendline support is at about 1500 on the S&P 500, currently trading at 1548.34, so the uptrend is no danger as long as it stays above that. If it falls below it, though, buying into volatility could be lucrative.

SEE: Technical Analysis: Support And Resistance

VXX speculate on market downturn

Another way to trade volatility is through the iPath S&P VIX Medium Term ETN (ARCA:VXZ). It is slightly less volatile than VXX, as it has a longer-term outlook. While VXX has fallen about 74% over the last year, VXZ has fallen 57%. So while less volatile than its counterpart, it has still declined substantially, losing most of its value on a long-term basis.

Once again, it is for short-term trading only. Support in this ETN is at $21.25, but volume has not really been escalating at the same level as VXX. If you are looking for a slightly more sedate way to hedge against, or speculate on, a stock market decline, this ETN provides another way to do it.

VXZ speculate on market downturn

The VelocityShares Inverse VIX Short-Term ETN (ARCA:XIV) rises as the stock market rises. If you don't believe volatility will escalate and that stocks will keep going higher, this is the one you want to buy. Since June 2012 the ETN has nearly tripled in value, going from a low of $8.06 on June 4, 2012, to a high of $24.17 on Feb.19, 2013.

That is where things get a bit weird, though. I believe this ETN is over extended and unlikely to move much higher. When the S&P 500 ran well past its Feb. 19 high over the last month, this ETN couldn't and is trading well short of its yearly high. The ETN is therefore showing weakness, which could potentially be foreshadowing weakness in the stock index. Either way this ETN looks posed to head lower and not higher.

SEE: Interpreting Support And Resistance Zones

XIV speculate on market downturn

The Bottom Line
It appears there are opportunities in volatility-based trades. The volatility indexes recently traded down to near historic lows, but seem to have found some buying support. The inverse volatility ETN is struggling to keep rallying, despite the stock market making new highs over the past couple weeks. Since volatility is based on the stock market, the opportunities in volatility signal there may be dangers ahead for stocks.

Charts courtesy of stockcharts.com

At the time of writing, Cory Mitchell did not own any shares in any company mentioned in this article.

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