A Resolution to Break Volatility Addiction

Stocks lost ground today, with the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the broader S&P 500 (SNPINDEX: ^GSPC  ) declining 1.2% and 1.1%, respectively. For the S&P 500, it was the fifth consecutive daily decline, the longest such streak in three months.

Breaking the volatility addiction
In this morning's column, I noted that the VIX (VOLATILITYINDICES: ^VIX  ) rose above 20 yesterday on an intraday basis yesterday for the first time since July 25. (The VIX, calculated based on S&P 500 option prices, is a measure of the market's expectations for stock volatility over the next 30 days.) Today, it gained another 16.7%, to close at 22.72 -- its highest closing value since mid-June.

That "volatility of volatility" did not go unnoticed by speculators: Two of the 25 volume leaders in U.S. equity markets today were not common shares at all, but VIX-related exchange-traded notes (ETNs). All told, trading volume in the iPath VIX Short Term Futures ETN (NYSEMKT: VXX  ) and the VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ: XIV  ) amounted to roughly $1.5 billion -- a staggering amount for negative-sum investment products.

Individual investors should avoid trading these and other, similar products, which serve as a hot potato that the fast-money set pass back and forth among each other, their aim being to slice off a sliver of potato before they burn their fingers. That's before even mentioning the risks associated with the design and robustness of these products. In March, the relationship between a similar ETN, the VelocityShares Daily 2x VIX ETN, and its underlying index collapsed; as a result, investors suffered a stunning 50% decline over a two-day period.

Here's a good resolution for self-confessed investors: In 2013, I resolve to observe volatility, to take advantage of it when Mr. Market offers up good quality equities at a discount to their intrinsic value, but never to trade it.

And speaking of discounts to intrinsic value: Bank of America is the best-performing Dow component in 2012, up over 100%. Despite this, the Fool's top banking sector analyst believes the shares still offer a margin of safety at current prices. To learn more about the most-talked-about bank out there, check out our in-depth company report on Bank of America. The report details Bank of America's prospects, including three reasons to buy and three reasons to sell. Just click here to get access.


Read/Post Comments (3) | Recommend This Article (2)

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  • Report this Comment On December 29, 2012, at 3:29 AM, thogshead wrote:

    Regarding "resolve to observe volatility, to take advantage of it when Mr. Market offers up good quality equities at a discount to their intrinsic value," if anyone is interested knowing how and when VIX volatility will change, Volatility Research accidently stumbled onto a pretty good way to predict VIX “fear gauge” volatility using NYSE VXX:

    http://www.sites.google.com/site/VolatilityResearch/

    The klinker in this market-woodpile is VIX volatility, and this year-long rally may prove to have been a house-of-cards.

    We’re in the lull before the Perfect Volatility Storm.

  • Report this Comment On December 29, 2012, at 4:53 PM, Mega wrote:

    "In March, the relationship between a similar ETN, the VelocityShares Daily 2x VIX ETN, and its underlying index collapsed"

    Actually what happened was that the relationship between the ETN and Index melted away in the months before that event, and then dramatically reappeared in March.

  • Report this Comment On January 01, 2013, at 5:53 PM, TMFAleph1 wrote:

    @MegaShort,

    I referred specifically to 'the relationship between a similar ETN, the VelocityShares Daily 2x VIX ETN, and its *underlying* index'

    On Mach 23 and 24, the S&P 500 VIX Short-Term Futures Index ER (which is the underlying index of the VelocityShares Daily 2x VIX ETN) rose 1.4% and declined 7.3%, respectively.

    By comparison, the VelocityShares ETN fell 29.3% and 29.8%, respectively.

    For more on this topic, see the article I wrote at the time:

    http://www.fool.com/investing/general/2012/03/27/dont-touch-...

    Best,

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