Like Selling Disaster Insurance

 | Jun 21, 2012 | 9:30 AM EDT  | Comments
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XIV

Wednesday was, yet again, an uncertain and unpredictable day in the markets. After futures pointed to a higher start, stocks opened in the red, climbed into positive territory, then settled back lower. As the Federal Reserve released its latest statement and assessment of the economy, stocks immediately tumbled -- apparently the extension of Operation Twist was less extensive than what many had expected. But just when it looked as if the sky was falling, equities did an about-face and surged higher, at one stage adding about 40 points from their opening level. Then it was back into the red in the late afternoon, leaving the S&P 500 and the Dow with slight losses on the day.

In other words, nobody knows exactly what's going on. The huge trading range Wednesday and sudden shifts in sentiment indicate to me that investors are searching desperately for direction, and that there is an abundance of conflicting reports over exactly where the economy is headed. We want to be optimistic, but the repeated disappointments of the past several years have taught us that no positive outlook goes unpunished. Uncertainty abounds, with many expecting a rally higher in coming weeks, while others are predicting a steep selloff as soon as the next eurozone crisis (Spain?) pops up.

This phenomenon is perhaps best illustrated by the market for futures in the CBOE Volatility Index (VIX). The VIX, which measures volatility in U.S. equity markets, settled Wednesday well below its long-term historical average. Despite the whipsaws in the Dow on Wednesday, the VIX shed almost 7% of its value. Now sitting just above 17, it's historically cheap -- and this is an indication that recent movements in markets have been relatively tame.

But you don't have to go far out the futures curve to get to see a meaningful jump in the so called "fear index." VIX futures for July, the next-to-expiration contracts, are trading at a premium of about 20% to the spot VIX. In other words, it seems as if investors are expecting a big jump in the VIX in the very short term. Or, perhaps more accurately, they are increasingly willing to pay a huge premium for this effective form of "portfolio insurance."

Steep contango is relatively common at the short end of the VIX futures curve, but not on the magnitude of 20%. That's a huge disconnect over a relatively short period of time. Investors are clearly afraid that there is more turbulence ahead, and they're paying through the nose to protect their portfolios from that unknown source of chaos. As a general rule, and in this case as it pertains to VIX futures, whenever the crowd is buying, it can be very lucrative to start selling.

For the holders of those July futures contracts to have any chance of making money, or for the writers of those contracts to risk being on the hook, the VIX needs to skyrocket over the next few weeks. That is, of course, entirely possible. There are plenty of sources of risk in the current environment, from Syria to China to the Fed to, of course, Europe. But if we don't see a big jump in the fear gauge, a strategy that shorts VIX futures would be positioned to make a killing in a very short period of time. That's precisely what the VelocityShares Daily Inverse VIX ETN (XIV) does -- it allows investors to play the role of the house, selling the disaster insurance that is in demand right now.

This ETN is one of the riskier products on the market: It's not uncommon to see it rise or fall 5% in a single trading session. But, right now, the odds are stacked clearly in the favor of this ETN. It has the wind at its back, and plenty of "padding" to generate gains over the next few weeks.

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