How to Profit From Volatility in 2012

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.
Click to Enlarge 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.
Click to Enlarge 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. Click to Enlarge 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.