2011 was one of the most volatile years for the market, and the S&P volatility index reflected this, trading in a huge range from 14.27 to 48.00. Several great short opportunities presented themselves. Several new ETN’s have made volatility plays a popular trade in 2011, with more heavy trading volume than in 2010. Let’s evaluate what may be coming up in volatility for 2012.
The VOLATILITY S&P 500 (^VIX) peaked at 48 in August, but we’ve had a bumpy ride settling in to the 23.40 close for 2011. Keep in mind, 23.40 is still above the VIX’s historical average. The VIX is a mean-reverting statistic, so eventually we will be going down from here once the markets settle. However, don’t expect to see this happen in the first quarter of 2012.
The December slide from 31 to 23 has come as quite a surprise to many traders. However, on lighter volume, and expected volatility in the market, it seems many investors are expecting greater volatility, but not protecting against it. The lack of put purchasing has caused a sudden drop in the VIX leading into 2012.
I am expecting elevated levels of volatility for the first quarter of 2012. I believe that the European Union will continue to dominate the headlines until a final resolution is implemented later into 2012. However, I don’t believe we will see as much fluctuation as we did in 2011. For those traders expecting to place some trades in volatility ETN’s, be very careful with your timing.
VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX): The 2x volatility tracker has proven itself to be very unreliable for traders. On large move days, it rarely moves even the same amount as the actual VIX. With VIX futures now in a deep contango, the daily rollover of TVIX will eat away almost all of your profit unless you time a big movement almost exactly. I would recommend staying out of TVIX for the first quarter. It’s a great short prospect if you are able to get a hold of shares.
iPath S&P 500 VIX Short-Term Futures ETN (VXX): Same story here. VXX has had some unpredictability in its tracking of the VIX. Both TVIX and VXX warn of this in their prospectuses, and on a long enough timeline, both of these are going to $0.00. First quarter of 2012, definitely stay out of VXX.
iPath S&P 500 VIX Mid-Term Futures ETN (VXZ): For those of us looking to play volatility, VXZ is not really our instrument of choice. Look for steep contango and light volume in VXZ, leading to tracking error and unpredictability.
VelocityShares Daily Inverse VIX ST ETN (NASDAQ:XIV): XIV will be an interesting play for the first quarter of 2012. Contango should leave to small amounts of daily profit in XIV as it rolls over all of its investments. However, big upward movements in the VIX can skew XIV’s price pretty bad. Keep in mind that volatility only has about 25% more to fall to reach its average, and that will not correlate to a 25% increase in XIV.
There are a few other volatility ETN’S on the market, but I don’t feel that any of them are worth mentioning or offer a better outlook than what we have here. In 2011, there were many great trades to make in TVIX, VXX, and XIV, especially the option plays on VXX. In 2012, don’t expect too many great opportunities to capture big movements. Even being 1 or 2 days off on a trade will be enough to eat away any profit to be had. VXX options are overpriced and overcrowded, TVIX doesn’t offer options currently, and XIV does not have much wiggle room to play with.
This leads me to my two closing points for the VIX in the first quarter of 2012:
1. The unexpected drop in the VIX for December of 2011 hurt many traders. However, for long-term investors, it may mean that protective puts are underpriced. January would be a good time to pick up some puts to protect your portfolio against any large downward movements in the first quarter. You will also be able to do this at a cheaper price than during 2011. If you are prepared to see some up and down movements in your portfolio for 2012, I would leave the puts to portfolio managers. However, conservative investors can get some great prices on puts right now.
2. There will still be 4-6% movements in the VIX for 2012. There will more than likely not be 4-6% movements in TVIX, VXX, VXZ, and XIV. What does that mean for traders? It means do not trade these ETN’s. If you want to make a volatility trade, stick to actual options on the VIX. They will be the most accurately tracking trade for the first quarter of 2012. Expect lower returns than in 2011 and set your stop-losses.
In conclusion, 2011 was a great year for those who could predict volatility movements. Volatility ETN’s gave us a great way to get some above-average returns on wild swings, and a long period of backwardation gave TVIX and VXX an advantage they don’t usually have. For the first quarter of 2012, don’t expect the same results. The VIX appears to be returning to its average, and swings are getting smaller. As investors become used to the idea of higher volatility in day-to-day trading, options purchasing will return to normal, and this will be reflected in a lower VIX reading.
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