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How to Profit From Volatility in 2012

Strap into an ETN and let the market roller coaster begin


Early January is the time for stock market predictions, and analysts and pundits everywhere have dusted off their crystal balls in a futile attempt to peer into the future and determine what 2012 will bring.

Of course, none of these people have a clue about where the stock market will stand one year from today because, unfortunately, no one can predict the future.

However, one prediction is safe to make: that a very likely feature of 2012 will be ongoing volatility in global stock markets. We’ve already seen volatility on the first day of trading of the new year with an impressive post-holiday pop that took the Dow Jones Industrial Average back to its highest level since last summer.

Taking a look back at 2011, most investors would agree that the volatility was nearly unbearable and that the year was one of the most unsatisfying in market history.

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A look at the chart for 2011 of the S&P 500 paints a clear picture of the volatility and sideways nature of the market. With high to low swings of 25% or more and seemingly daily swings of 1% to 3%, volatility was the name of the game as price swings reached levels not seen since the 1930s.

But through it all, the S&P 500 remained virtually unchanged — and, in fact, 2011’s “movement” was the smallest seen since 1970. So, with intense volatility going nowhere, what is an investor to do?

My answer is, “If the markets are volatile, why not trade volatility?”

The CBOE Volatility Index, or VIX — also known as the “fear indicator” — uses the implied volatility of S&P 500 Index options and is an index of the market’s forward looking view of volatility for the next 30 days.

This indicator is widely viewed as a way to measure market risk and forecast future movements. Some observers say that when the VIX is low, market risk is low and stock prices are likely to trend higher. This camp also says that when the VIX is high, lower stock prices are ahead as fear is the dominating force in the market.

On the other hand, contrarians say to “sell the greed, buy the fear,” and so when the VIX is low, contrarians would be anticipating declines in prices ahead — and when it’s high, they would be expecting a reversion to the mean and lower prices ahead.

Whatever happens in 2012, I’m certain there are going to be opportunities to trade volatility in both rising and falling volatility environments as the major indices go through their regular gyrations. Therefore, two of my favorite ETNs for 2012 likely will be those that track “long” and “short” directional moves in the VIX.

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For rising VIX environments, the iPath S&P 500 VIX Short Term Futures ETN (NYSE:VXX) is a popular, liquid and widely traded ETN designed to rise in price as the VIX rises.

In the chart, you can see how the volatility ETF is, well, volatile, and moves inversely to the major U.S. indices.

For declining volatility environments, VelocityShares Daily Inverse VIX Short Term ETN (NYSE:XIV) is designed to rise in price as the VIX declines.

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More aggressive investors can consider VelocityShares Daily 2X Short Term ETN (NYSE:TVIX), which offers a double-leveraged position for trading volatility.

So on the long side, ETNs exist to seek profits when volatility is rising, and the inverse ETN can offer potential when VIX is in decline. For cash accounts, one also can short the VIX ETNs, and aggressive options traders also have opportunities in these widely traded vehicles.

While these ETNs can offer potential profit opportunities, you must educate yourself before trading these volatile instruments. These are not perfect vehicles — they come with tracking error and can expose you to wide swings of both profits and losses. Therefore, you must do research on the ETNs themselves before treading into these waters.

Disclosure: Wall Street Sector Selector currently holds a position in XIV. Wall Street Sector Selector actively trades a wide range of exchange-traded funds and positions may change at any time.

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