A prolonged period of low volatility, which has been the dominant case in the market over the past year, is a common sign that investors are becoming or already are complacent. It should just about go without saying that, when the broad market becomes careless with its capital, it is often a strategic decision to turn defensive. With the rise in popularity of exchange-traded funds (ETFs) that are used to track the volatility index, also known as the fear index, it is now possible to hedge or bet on rising or falling levels of volatility. In this article, we look at several charts that can be used to trade the rise in volatility and try to determine how active traders will look to position themselves over the weeks ahead.
One of the most popular exchange-traded products used by retail and professional traders to gain exposure to volatility is the iPath S&P 500 VIX Short-Term Futures ETN. The VXX ETN has been the topic of much discussion in the media in recent months because of massive trade currently under way that is destined to make approximately $265 million in profit in the event that a set of very specific conditions are met. (For more detail, see: Traders 'Shocked' by VIX Bet That Could Pay $265M.)
Taking a look at the chart below, you can see that the ETN has been trading within a defined downtrend. However, the recent rise in volume combined with the break above the trendline now suggests that the story is changing and that higher levels of volatility could be coming. Heightened volatility could also be used to suggest that the markets could be nearing a turning point and heading for a pullback toward long-term levels of support. (For related reading, check out: Tracking Volatility: How the VIX is Calculated.)
For active traders who are convinced of a trade and look to maximize the profit potential by utilizing the power of leverage, one potential product to consider is the Proshares Ultra VIX Short-Term Futures ETF. This fund is designed to match two times (2x) the daily performance of the S&P 500 VIX Short-Term Futures Index. Taking a look at the chart, you'll see that the pattern looks nearly identical, but that the relative performance of the bars is twice as much as that shown on VXX. The recent close above the 50-day moving average, which has consistently prevented the price from increasing, could be the signal that many have been waiting for to trigger a significant move higher. (For further reading, see: The Volatility Index: Reading Market Sentiment.)
Active traders who are not quite convinced that the breakout is signaling a trend reversal may want to investigate the VelocityShares Daily Inverse VIX Short Term ETN. If markets shake off the recent weakness and continue to trend higher, then buying near the identified support levels could make for an interesting entry point. (For more, check out: Determining Market Direction With VIX.)
The Bottom Line
Volatility-driven funds are an asset class that most retail investors don't think of owning. However, given the charts shown above, it is my opinion that the recent surge in volume and move above the trendline on key charts such as that of VXX could be an early warning sign of more volatility to come. At the very least, the charts could be one reason to consider hedging an overweight equites portfolio. (For more, see: The VIX: Using the 'Uncertainty Index' for Profit and Hedging.)
Charts courtesy of StockCharts.com. At the time of writing, Casey Murphy did not own any of the assets mentioned.