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ETFs to Hedge Against Scary Earnings

By ETFs

As the earnings season goes into full swing, many have anticipated lackluster first quarter results, which could unhinge the recent market recovery off the February lows. Consequently, traders may consider small positions in CBOE Volatility Index, or VIX, (VIX) related exchange traded products to hedge their long positions.

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The CBOE Volatility Index was hovering around 13.7 at Thursday's close, near its lowest level this year and below its historical average of between 15 and 20, as investment anxiety dissipated with U.S. equities moving back toward all-time highs.

However, we are still in the midst of a so-called earnings recession in the S&P 500, with FactSet anticipating the benchmark index to show an earnings decline of -9.1% for Q1 2016 and S&P Global Market Intelligence also projecting S&P 500 Q1 EPS to decline 7.5% year-over-year.

Consequently, investors who are wary of potential headaches in the weeks ahead can hedge against a complacent market with the VIX. The VIX is a widely observed indicator for investor sentiment in the stock market and measures the expected or implied volatility of large-cap stock options traded on the S&P 500 index. Exchange traded products that track VIX futures allow investors to profit during rising volatility or hedge against short-term turns. 

Nevertheless, investors should keep in mind that the majority of VIX ETPs are designed to track CBOE Volatility Index futures contracts, not the VIX spot price, so the VIX ETPs may not perfectly reflect VIX spot price changes.

For example, the iPath S&P 500 VIX Short Term Futures ETN (VXX) and ProShares VIX Short-Term Futures ETF (VIXY) are among the largest VIX-related ETP options available to ETF investors.

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The World of ETFs...

VXX tries to reflect the performance of the S&P 500 VIX Short-Term Index Total Return index, which is comprised of first and second month VIX futures contracts. Currently, VXX includes a 85.5% position in CBOE VIX Future May '16 and 14.5% in CBOE VIC Future April '16.

Potential investors should note that VXX is an exchange traded note and not an ETF. ETFs and ETNs carry different risk attributes but fulfill the same basic function. An ETN is an unsubsidized debt security issued by an underwriting bank, which may leave investors open to default risks. With an ETN, an investor can lose some of all of their investment if the ETN issuer goes bankrupt. On the other hand, the ETN structure does advantageous tax treatments - gains are reported on a 1099 form and are subject to taxes only when the investor sells the note and, then, only at the long-term capital gains rate.

VIXY tries to reflect the performance of the S&P 500 VIX Short-Term Futures Index, which maintains an average weighted settlement date of one month by rolling a portion of the posiion in the first month VIX futures contract into the second month VIX contract on a daily basis. VIXY currently holds a large position in CBOE VIX Future 05/18/2016 contracts and a smaller position in CBOE VIX Future 4/20/2016 contracts.

Since these ETPs track futures contracts, investors will also be exposed to contango. If the futures market is in a state of contango, a futures contract that is set to expire will cost less than later dated contracts. Consequently, as the ETPs roll futures contracts ahead of their expiry date, the ETPs will essentially sell low and buy a costlier later-dated contract, which could eat into returns over the long run. For instance, the current April 20, 2016 VIX contract recently settled at 14.675 while the May 18, 2016 VIX contract settled at 17.275.

Additionally, for the more aggressive traders, the leveraged ProShares Ultra VIX Short-Term Futures (UVXY) and VelocityShares Daily 2x VIX Short Term ETN (TVIX) could provide greater returns, but the options come with greater risks.

UVXY follows the two times or 200% daily performance of the S&P 500 VIX Short-Term Futures Index and acts as the 2x leveraged version of VIXY.

TVIX also takes the 200% daily performance of the S&P 500 VIX Short-Term Futures Index. The ETN includes 81% CBOE Short-Term VIX Future May 2016 contracts and 19% CBOE Short-Term VIX Future April 2016 contracts.

This article was provided by our partners at etftrends.com.

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