BALTIMORE (Stockpickr) -- The added volatility that stocks have seen so far this month has been more than just headlines -- it's produced a palpable shift in the way investors are looking at the market right now. Enter the CBOE Volatility Index -- better known as the VIX. This index, which measures the implied volatility of S&P 500 index options, was nearly unheard of to most Main Street investors until 2008, when market volatility ballooned in the midst of bursting real estate and credit bubbles.
But while more investors are familiar now with the VIX, investing strategies for a volatile matter are a different story. To close that gap, here's a look at three investment strategies that can help you profit when
1. Check Your Allocation
The first step to profiting from volatility is to reassess your trading strategy. Whether you're a short-term trader or a buy-and-hold investor, there are ways that you can minimize the risk of holding on to stocks when the market's unstable.
As a short-term trader, volatility is essentially your friend. Increased volatility means that your trades will see higher-percentage moves in a shorter amount of time. The danger with that, of course, is the fact that being on the wrong side of that volatility can result in some crippling losses. Last Thursday proved that for many market participants.
One strategy for traders to consider is derivatives. Historically, derivatives plays were the only way to place a bet on volatility. And while new options have opened up to less-sophisticated investors -- more on those in a bit -- they continue to be an effective way to place a bet on volatility. Derivative volatility strategies (such as volatility arbitrages trades in options or buying VIX futures) are complicated trades, and the implications of making a mistake can be large. Only delve into these if you're confident in your familiarity with the trades.
But what about a strategy for longer-term investors?
In principle, volatility isn't supposed to matter for long-term investors. Holding an investment over a long time horizon essentially negates the short-term ebb and flow of the market. But in reality, few investors want to subject their portfolios to losses, even when times are bad. If you're considering reallocating your long-term portfolio for a volatile market, focus on stocks that have low betas (a measure of a stock's relative risk).
2. Leveraged ETFs
One of the results of the ETF boom of the last few years has been the emergence of leveraged index ETFs. These exchange-traded funds mirror the major indices, such as the S&P 500 or
, but their movements are multiplied. In essence, leveraged ETFs provide you with a way to supercharge your gains (or losses) in a short time.
One popular leveraged fund is the
ProShares Ultra S&P 500 ETF
, which was designed to return twice the daily performance of the S&P 500. So while the S&P is up only about 5% since the start of 2010, SSO is actually up 10% year-to-date.
Leveraged ETFs have sprung up in all sorts of flavors, offering investors everything from a double negative bet on the Dow Jones Telecom Fund with the
ProShares UltraShort Telecom ETF
and a triple-leveraged long bet on the financial sector with the
Direxion Daily Financial Bull 3X ETF
Of course, the main limitation of leveraged ETFs is the need to bet on which direction the market's going. If you're long with a leveraged ETF and the market falls, your money will disappear twice as fast as it would if it were just invested in unleveraged stocks. Leveraged ETFs also have some issues with long-term tracking error that make them lousy long-term investments. For the short term, however, these funds offer a good way to essentially increase the volatility at your disposal.
3. VIX ETNs
The need to know which way the market's will swing is a major limitation of leveraged ETFs. What if you just want to bet that volatility will continue to increase?
That's finally possible now thanks to the
iPath S&P 500 VIX Short-Term
, which give investors exposure to short- and mid-term futures for the VIX index.
These exchange-traded notes are a little different from ETFs in that they represent debt-backed securities instead of equity. Essentially, the issuer of the ETN, Barclays Bank, is promising that if you buy its note it'll provide returns that correspond to the VIX futures, but it can achieve those returns however it wants.
Ultimately, however you choose to bet on volatility, a substantial amount of risk will be involved -- but the profit potential for making a good trade can be substantial.
For more volatility plays, check out the
-- Written by Jonas Elmerraji in Baltimore.
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Jonas Elmerraji is the editor and portfolio manager of the
Rhino Stock Report
, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including
, and has been featured in
Investor's Business Daily