Events Trader # 16: How to profit from the autumn jitters

25th August 2009

How to profit from the traditional Autumn surge in volatility

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Welcome back.

We're nearing the end of August and the holiday season. Soon everyone will be back at their desks and business as usual will resume. So what does that mean for markets?

So far the equity market rally that started back in March has carried on with only minor interruptions. But with the arrival of autumn, we should finally see if the economy will start to grow again, as markets expect, or if it will remain anaemic or even contract again.

So far, it's looking like the optimists have the edge, and that growth is around the corner. But they'd better be right. If we don't see the goods, and the economy doesn't start to grow again, stock markets could be left at dangerously high levels.

This is particularly crucial at this time of year. Historically September and October have proven to be the two of the most volatile months for equity markets. This may be due to the fact that after the summer lull, investors start to re-evaluate the economic situation. Coupled with a flood of new information on companies and the economy in general, this is enough to increase volatility in the markets.

You see a similar impact in January, when institutions start putting money to work (January tends to be one of the best months for equity markets), or in April, when the end of the tax year in both the US and UK sees investors crystallise losses and roll over profits, causing underperforming stocks to fall even further, and outperformers to rise slightly.

What is volatility anyway?

Volatility is basically the measure of how much a market or stock moves, or is expected to move, over a given time. Note that it tells you nothing about direction, just the size of the move. I will spare you the mathematical detail on how it's calculated (it's pretty complicated). The main thing to understand is that volatility can be measured, and the most well-known measure of market volatility is the VIX index. And this is where our next opportunity lies.

What is the VIX index? It measures what's known as the implied volatility of the S&P 500 index, based on a range of options traded on the index. Options give a trader the right to buy or sell stocks at a future date, which means they can be used to hedge against big swings up or down in an asset or market's value. The more uncertain the future direction of the markets is, the more expensive these options tend to be. Hence, the VIX index is also known as Wall Street's "fear gauge" as it tends to rise when investors are wary about the future.

The graph below shows the movements in the VIX index over the last three years.

As you can see, before July 2007, volatility dipped below 10. I remember that back then, just as in 1999, there was talk of a new era, one of low risk and low volatility, helped by increasingly sophisticated risk management techniques.

And just as tech investors learned to their cost in 2000, so the more recent prophets of a new beginning were proved wrong when the credit crunch hit. Volatility rose again on the back of the credit crunch and the financial crisis that followed, reaching a level between 20 and 30, in line with the long term average.

Things then got hectic between October last year and March this year. At one point the VIX went above 80 as people started to worry that the end of the world as we know it was around the corner.

Since then the VIX has retreated to a more reasonable 25, helped by the renewed confidence that the recession is nearly over, and by the summer lull.

This gives us a profit opportunity. I still believe we are in uncertain economic times, and yet the VIX index is in the middle of its long-term range. This can't last - and there's a way for us to profit from it.

How can we profit from a rising VIX index

As I noted above, historically September and October tend to be the two most volatile months of the year. So that makes now a good time to take a long position in the VIX index.

This can be easily done using an exchange-traded note (ETN) issued by Barclays Bank. This is

the iPath S&P500 VIX Short-term Futures ETN. It's listed in the US, and the ticker is VXX. You can read the prospectus here: https://www.ipathetn.com/pdf/vix-prospectus.pdf1

Note that ETNs are slightly different from exchange-traded funds (ETFs). I'll explain the difference below in the risk section.

Anyway, what this ETN does is quite simple - it just tracks the VIX index (for anyone who's interested, it does this by replicating the underlying index, which it does by purchasing short-term futures on the VIX, with 1 and 2 months' maturity and regularly rolls them over - it's like having someone trade the VIX index on your behalf).

It began life on the 29th of January this year at $100 when the VIX was around 70. It briefly hit $120 in March, but has since halved as a result of falling volatility, and is now trading at $56.70, its lowest level since launch.

VXX has also a little brother VXZ which tracks the VIX index over the medium term and purchases futures with an average maturity of five months. But it's not very liquid, so you can check it out if you like, but because of the liquidity issue, I would recommend the VXX.

What to do now

The strategy is very simple. Buy the iPath ETN at around $55 - $56.50, and wait until the end of September for the volatility to rise. I would place a provisional stop loss around $50 just in case. At the end of September we will review the situation and see what has happened.

The VIX index has already dropped from 80 down to 25. It's quite possible that if some bad news hits the market next month the index could easily rise back above 30 and maybe more. As I already mentioned, the long-term average for the VIX is between 20 and 30, and to be honest with you, I doubt volatility can fall much further given the still perilous state of the financial system and the global economy.

How to trade

Trading should be relatively easy. The VXX is US listed and can be bought and sold using most online brokers. The commission charge should be similar to trading a share. One thing to be careful of is that the spread between the bid and offer prices can be quite wide, even although trading in this ETN has been rising recently. So when you buy it, try to sit on the bid and always use a limit order.

It might even be worth trying to place orders with limits below the bid just in case the VIX falls.

Risks

The main risk here is the tracking error; or the danger that the realized volatility in the market does not translate into a similar move in the VIX future that this ETN holds. To be specific, the ETN tracks VIX futures, not the underlying VIX index , so it's possible that there could be a situation where the index moves, but the future fails to move by a similar amount. This type of error might occur if the S&P 500 experiences some sort of stress, such as at the beginning of the year.

The second risk here is the nature of the product. While ETFs are funds with segregated assets, ETNs are notes backed by the issuer, in this case Barclays, so if the bank fails you are just another creditor. In our case we expect to hold this position for at most two months, so Barclays should not go bust in this period of time. Just to be clear though, your claims as a holder of the ETN would be higher than those holding equity, tier 1 or tier 2 debt issued by Barclays - so you'd be pretty high up in the queue if the bank did go bust.

The last risk here - for sterling investors and other non-dollar investors - is currency risk, because these ETNs are priced in $ and traded in New York. Unfortunately the US markets are way ahead the European markets in term of liquidity, risk management and financial innovation. So this sort of product tends to be created in the US and then exported, and even after they have been exported similar European products tend to have lower liquidity. I have talked extensively about currency risk hedging in past issues of Events Trader, so I will direct you the past issues for an extensive discussion on how to hedge your currency risk.

Recommendation:

Buy: iPath S&P 500 VIX Short-term Futures ETN

Ticker: NYSE: VXX

Buy limit: Buy between $55 and $56.50

Stop loss: $50

Target: Hold until end of September then review

Chart of iPath S&P 500 VIX Short-term Futures ETN since launch:

News on Tier 1 and upper Tier 2 debt issued by Northern Rock

Last week Northern Rock decided to suspend interest payments on tier 1 and upper tier 2 bonds to improve its capital position. The decision also pre-empted a possible request by the European Commission to stop payment on subordinated bonds as a condition of state aid. The European Commission asked Bayer Landesbank in Germany and KBC in Belgium to stop paying interests on tier 1 and upper tier 2 as a condition for the approval of state aid.

The rationale for this decision is to allow the bank to use the interest payment to strengthen the capital of the bank. This decision affects around £1.7bn in subordinated debt issued by Northern Rock. But it's important to stress that these bonds are not in default! They just do not pay interest and have been transformed from an investor point of view to zero-coupon bonds (at least until further news).

This news could (and I stress could) also have implication for RBS and Lloyds, which are partly owned by the taxpayer and could be put under pressure to suspend payments on their junior debt. However, the big difference here is the fact that Northern Rock is fully nationalised and relies solely on the government for its capital base, whereas RBS and Lloyds are still in effect listed on the markets and therefore use the market as a primary source of funds.

This means that if RBS and Lloyds were to suspend interest payment on their subordinated debt, their Tier 1 bonds would fall temporarily and their share price would plunge, leaving them in effect cut off from the possibility of raising further funding in the market. The conclusion is that RBS and Lloyds would benefit more from paying interest than from suspending it. It's also worth remembering that when Northern Rock was nationalized it was not insolvent (assets worth less than liabilities).

I will keep you posted with further developments and I will look into the junior debt of Northern Rock to see if we can make some money out of it. In the meantime if you want to get in touch with me for advice, information or even if you have a trading idea, e-mail me at my usual address: eventstrader@f-s-p-co.uk.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.

Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.

Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.

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