How to leverage Volatility to Maximize Portfolio Returns

Tim Fortier |

stocks improvingWith only 14 trading days left in 2011, its almost compulsory to take some time to review what’s happened over this turbulent year—and more importantly—what to do for 2012.  This is especially true when it doesn’t look like this market turbulence is going to end anytime soon.

Looking back on price alone, it would appear that 2011 has been pretty uneventful for U.S. investors.  Considering that the opening price in for the SPDR S&P 500 (SPY) was $124.89 at the beginning of January and today (12/12/11) the price is $125.89

Yet, a quick glance of the VIX Volatility Index paints a very different story!

The index displays levels of volatility rarely seen in recent years.  Often referred to as the “fear index”, it is quoted as a percentage and, represents investors’ expected price movement in the S&P 500 over the next 30 days.  It suggests that investors have become less complacent in recent months.

The index began the year under 20 but investors sent the index soaring to levels over 40 for much of August and September. And the index currently remains some 60% higher than where it started at the beginning of the year.Equities.com VIX Daily Index

Let’s be honest...There’s a lot to be concerned about in today’s markets.  Whether its record sovereign debt, concerns over inflation, concerns over deflation, the continual collapse of confidence in Europe, the housing market, or unemployment just to name a few—I firmly believe  the market volatility is NOT going away.  In fact I expect it to increase.

So how can you use market volatility to maximize your portfolio?

Unfortunately, the magnitude of the actual VIX index is computed using the prices of certain put and call options—so a direct investment in the index is not possible. However, innovations over the last few years have allowed investors to gain exposure to an entirely new “volatility” asset class.

While futures linked to the VIX debuted in 2004 and options on the VIX began trading in 2006, the rise of ETF’s further democratized this asset class.  The first exchange-traded products linked to indexes comprised of VIX futures debuted in early 2009.  And in the two years since then … more than a dozen additional VIX-related products have been brought into the market.

The iPath S&P 500 VIX Short-Term (VXX) and VelocityShares Daily 2x VIX Short Term ETN (TVIX) are among the most actively traded volatility-linked products.  Of these, the VXX boasts the greatest asset base and highest daily volume.

As of 11/30/11, the trailing 6-month performance of the VXX was 97.28% and the YTD return was 11.86%.

The correlation of VXX typically runs around -.88 meaning that it tends to perform close to opposite of the S&P 500.  The idea here is if investor “fear” is in increasing—stock prices will likely be heading lower—and the VXX should be moving higher.

This presents an opportunity for you to use the “fear” in the market to your advantage.  And as I said before … it doesn’t look like fear will be leaving the market anytime soon.

Before you start to implement a VXX strategy here are a few quick words of caution.  

First, instruments like VXX are not suitable for long term buy and hold strategies.  During periods of investor complacency, the level of the VIX index will decline and the value of instruments like the VXX will do the same.

A second point is that due to nuances in the construction of many of the VIX related ETFs and ETNs, performance will likely be less than the return of the index itself.  Even so, this year’s performance  figures on VXX clearly show how owning these instruments can provide an alternative source of positive return during periods when investor anxiety is running high..

Click here to learn more about the Portfolio Café and trading the VXX to maximize portfolio returns.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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