The Soaring Dow Has Made This Smart Strategy Cheaper
Nov 8th 2013 12:31PM
Updated Nov 8th 2013 12:40PM
Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.
As has happened so many times during the bull market since 2009, yesterday's 153-point pullback in the Dow Jones Industrials appears to be just a one-day phenomenon, with the average recovering more than half of its lost ground as of 12:15 p.m. EST on optimism about positive jobs numbers and the potential for further economic growth. In the process, investors have gotten extremely complacent in their views about future volatility, as the S&P Volatility Index fell back after a nearly 10% jump yesterday. The volatility-tracking iPath S&P 500 VIX ST Futures ETN dropped back toward all-time lows after executing a 1-for-4 reverse split this morning, while the leveraged VelocityShares Daily 2x VIX ST ETN declined 7%.
Among those who believe the Dow has come too far too fast and is overdue for a correction, volatility-linked products have held the promise of providing big returns when the stock market drops. But over the long run, those products have produced big losses during the bull market, as short-term concerns have thus far always given way to resolutions that sent stocks back upward and volatility measures falling further. Indeed, professor Robert Whaley, who is credited for creating the volatility index, recently told the Journal of Portfolio Management that the products are "virtually guaranteed to lose money through time."
However, one smart strategy that doesn't involve volatility ETFs can give nervous investors a degree of protection from a coming downturn. The VIX measures levels of volatility implied by prices of options contracts on stock market indexes. As levels of nervousness rise, investors are willing to pay more for protective put options that can hedge against losses in the market.
Today's high level of complacency, however, equates to relatively cheap prices on put options. That opens the door for nervous investors to buy put protection for their portfolios more inexpensively than if they waited for a decline to begin to take hold. Even though options still have a high degree of risk involved with them, the prospect of getting short-term insurance against a market decline might appeal to many investors right now.
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The article The Soaring Dow Has Made This Smart Strategy Cheaper originally appeared on Fool.com.Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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