You've heard it before: "Stocks are just too volatile right now."
So is volatility really a bad thing? And what the heck is volatility, anyway? We'll talk about it today.
As you'll see, volatility cuts both ways. Wise investors use it to their advantage. A new — and growing — category of ETFs and ETNs can help you tame the wild beast.
What Is Volatility?
If we made a list of the most misunderstood investment terms, "volatility" would be near the top. When the average investor is told something like "The stock market is volatile," what he hears is typically "It's going down!"
This is not correct. Look it up in your favorite dictionary. You'll see that volatility is nothing more than another word for "variability" in an investment's value.
A price can vary either up or down while staying equally "volatile." Volatility simply means that an asset's price is moving. The directionin which it moves is irrelevant.
|Volatility goes both ways.|
That's what the dictionary says. However, when investors say they want to avoid volatility what they usually mean is they want to avoid losses. In fact, most people love volatility as long as it works in their favor!
Now in real life it's not so simple. We don't know the future, so we don't know how volatile an investment will be. At best we can make an educated guess based on past events.
Volatility in a Bottle
Your guess about volatility, while it is only a guess, does matter. If you own an asset that has a history of suddenly jumping in value, someone who thinks another such jump is imminent may be willing to pay you a higher price.
|Professionals watch volatility — and use it to their advantage.|
For this reason, professional traders pay a lot of attention to historical volatility. They track it with computer models and compile the results into indexes.
In the last few years, some of these volatility instruments have been packaged into exchange-traded funds and exchange-traded notes. My latest count shows around 30 volatility-based ETFs and ETNs are now available to U.S. investors.
Are any of them right for you? Maybe, maybe not — but they can still be useful. Just watching their activity can help your investment strategy. Here are a few you may want to put on your radar screen:
- iPath S&P 500 VIX Short-Term ETN (VXX)
- iPath S&P 500 VIX Mid-Term ETN (VXZ)
- ProShares VIX Short-Term Futures ETF (VIXY)
- ProShares VIX Mid-Term Futures ETF (VIXM)
While VXX and VXZ have more history, I'm wary of their exchange-traded note structure. The ProShares offerings are very similar but do not expose investors to issuer credit risk.
How would you use these?
All four are based on derivatives of the S&P 500 Volatility Index — the "VIX" in Wall Street lingo. When markets get crazy, the VIX tends to spike higher. Ideally you would want to buy volatility before the craziness hits. Easier said than done, I know, but these products make it easy to try your luck.
Want to Limit Volatility?
ETFs Can Help You There, Too!
Suppose you've analyzed your investment goals along with your personality. You know you need to be in stocks, but you also admit you may get cold feet.
|Sometimes you might want an easier ride.|
In other words, you want some volatility but not too much. Can you participate in stocks without the full-scale roller coaster ride?
Yes, you can, with a new breed of volatility-controlled ETFs and ETNs. Direxion, for instance, just launched three "volatility response" ETFs. They try to target a specific risk level (15 percent annualized standard deviation, to be specific) by adjusting the split between stocks and fixed-income assets.
You can pick from two U.S. equity indexes or a Latin America index:
- Direxion S&P 1500 Volatility Response Shares (VSPR)
- Direxion S&P 500 Volatility Response Shares (VSPY)
- Direxion S&P Latin America 40 Volatility Response Shares (VLAT)
Barclays has an ETN with similar objectives, but it tries to reduce volatility by moving partly into VIX futures rather than cash-like instruments. It is called the Barclays ETN+ S&P VEQTOR ETN (VQT).
As you can see, the ETF industry is drilling deeper and deeper into the specialized areas once available only to sophisticated institutional investors. Whether you want to trade volatility or not, it's exciting to watch this phenomenal change. Keep your eyes open for more!
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