Betting on rising volatility

The VIX has been surprisingly low lately, given the escalating debt concerns and austerity packages in Europe, the inflation concerns in China and Brazil, and the rapid pace of regulatory change in the US.  There are 2 ETF’s which are supposed to track the VIX: VXX and VXZ.  Other alternatives such as betting on gold, oil, against the S&P or high beta stocks don’t really correlate well with the VIX and are best thought of in terms of their core characteristics.

VXX is based on short-term futures, and it certainly correlates somewhat with the VIX, but the transaction costs must be enormous because charts show it rapidly losing value over time.  The fast drop in the VXX in short periods where the VIX remains steady make the it seem like dumping money in the toilet and flushing, betting it will eventually overflow and give you something back. 

The VXZ, based on intermediate-term futures, actually solves this problem.  However, it doesn’t correlate with the VIX, but does a somewhat decent job against the 60-day exponential moving average of the VIX.  See the following chart:

You can see how the movement of the VXZ is somewhat sluggish and the volatility is muted, just like the EMA of the VIX.  Notice that the spiking of the VIX from 15-45 in April-May resulted ultimately in an increase of 65-95 on the VXZ, and that the lower peak of the VIX around July 1 was a slightly higher peak for the VXZ at 98.  You can also see the comparison with the costly VXX. 

The VXZ is definately useful in betting on volatility as long as you keep a few things in mind:  The bet is on sustained and not sparradic volatility, the change will not be as big as you’d expect, and this is not a long-term investment but a timing play on how volatility will move in the next few months.  With the sluggish averaging movement, it might be best to wait after the initial move up in the VIX before buying VXZ and likewise to wait for the initial move down before selling.

Change of subject warning – on natural gas and gold:

I am still waiting on the sidelines with unallocated cash like before.  I did buy some natural gas plays for my Roth IRA (US ones so dividends won’t be taxed) and in retrospect it would have been better to bet on Canadian producers.  See this article on the EPA looking into regulating US based NG drilling:  http://online.wsj.com/article/SB10001424052748704679204575646942322414092.html

I’m also a bit nervous on gold still, mainly because it’s so overbought.  I realize that it’s an excellent play with the European Debt situation and possability of ECB balance sheet expansion, but it seems that a lot of this must be priced in.  The funny thing about the ECB expanding it’s balance sheet to buy peripheral government bonds is that the inevitable haircut Euro-bondholders must receive would then be bourne primarily by those betting in German bonds – as their low rates hold much more inflation/currency devaluation risk.  The Germans aren’t stupid and will fight this idea – and China and Brazil are worried too much about inflation right now to exacerbate currency wars.  If gold pulls back to the 1250 range, or more importantly if the number of long contracts goes down – I’ll buy back into the GLD though.  Here’s a chart from Dave Rosenberg’s 11/30 newsletter showing what I’m talking about:

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About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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