The Best Ways to Profit From the Dow's Volatility

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Few things are certain in the investing world, but one rule almost always holds true: Nervous investors don't like to buy stocks. The government shutdown has put investors on high alert, with the Dow Jones Industrials (DJINDICES: ^DJI  ) having given up 900 points in less than a month as Wall Street and Main Street alike consider the impact of the government shutdown and the debt-ceiling impasse on the economy and their investments. The Dow's choppiness today has been characteristic of market moves lately, with the Dow trading near the unchanged level as of noon EDT after moving both upward and downward earlier in the session.

In times of trouble, attention moves to the so-called Fear Index. The S&P Volatility Index (VOLATILITYINDICES: ^VIX  ) was up another 1.2% as of noon, briefly hitting levels seen on just two occasions in the past year: following the June Federal Reserve announcement concerning possible QE tapering and during the fiscal-cliff crisis.

Astute investors always wonder whether there are ways to profit from volatility. That demand is the key reason why financial institutions created volatility exchange-traded products. Volatility-trackers like the iPath S&P 500 VIX ST Futures ETN (NYSEMKT: VXX  ) have become immensely popular, and as you'd expect, they tend to perform well in times of trouble. This iPath ETN has climbed more than 25% just since the last week of September, while its leveraged peer, the VelocityShares Daily 2x VIX ST ETN (NASDAQ: TVIX  ) , has jumped 50% in the same time frame.

These investments give their shareholders exposure to the moves in volatility futures contracts, which themselves are fairly complex derivative securities based on expectations of where the Fear Index will be in the short run. The ETNs don't track the daily Fear Index moves precisely, but as you can see from their recent performance, they often follow suit generally by moving in the same direction.

Waiting for a crisis
Volatility-tracking investments produce big gains in a crisis. The problem, though, comes when crises aren't happening.

Looking back just at 2013 shows the potential for losses from owning volatility ETNs when markets aren't particularly volatile. Even after its recent gains, the iPath ETN has lost almost half its value so far in 2013. The VelocityShares ETN has done even worse, as its leverage has produced more dramatic losses of almost 80%.

Investors who've taken the other side of that bet have received big rewards. The VelocityShares Daily Inverse VIX ST ETN (NASDAQ: XIV  ) has climbed almost 40% in 2013, even after dropping more than 20% in the market's most recent bout of volatility.

Big short-term gains are always nice to see. But as long-term plays, volatility-tracking investments don't give you as much winning potential as taking advantage of price drops to buy attractive stocks for the long haul. That strategy won't give you a quick payday, but it will likely serve you better over time.

Don't let volatility scare you out of the market
Market volatility is nothing new. Millions of Americans have waited on the sidelines ever since the market meltdown in 2008 and 2009, too scared to invest and thereby missing out on huge gains. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing is so important and what you need to do to overcome your fears and get started. Click here to get your copy today -- it's absolutely free.


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