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By: Chris Rowe — May 3, 2010

Here's How To Profit When The Market Tanks

Do you believe that, at some point in the next few years, investors in the U.S will be more fearful than they are today?

If so, I have a potentially huge money maker for you to add to your watch list.  I'm going to give you a vehicle that will be a game changer if you don't already know about it. 

It's an Exchange Traded Note (ETN) that moves up when investors are afraid, and comes down when they are complacent. 

The best news of all?  We don't have to worry about it going to zero.  It typically spikes and then trades flat again like an "E.K.G." reading. 

The Problem With Popular Bearish Trading Vehicles

I'm sure you have traded, or at least heard of, inverse Exchange Traded Funds (ETFs) that go up when the index it tracks declines.  But the problem with them is that the market can just keep moving higher and higher, causing the ETF to trade lower and lower until, finally, the inverse ETF moves so low that a decision is made to "reverse split" the thing so the price doesn't make the ETF seem like garbage.

Take Direxion’s triple inverse financial ETF, "FAZ". 

FAZ, which seeks 300% of the inverse daily performance of the Russell 1000 Financial Services Index, saw a sharp decline in 2009.  As financials had a sharp rebound, investors who took bearish bets by purchasing FAZ at 200 saw the ETF move from 200 down to 5.40. 

The ETF had a 1 for 10 reverse split, leaving it at $5.40.  But back on July 9th, it was priced at $55.40, and if you owned 100 shares, you ended up with 10 shares (so the value of the position remained the same).  Since then it's traded further down from 55.40 to 11.65 (which means, pre reverse split, it went from $200 to $1.16).

While the moves seen in FAZ, a "triple reverse" ETF, are rather dramatic, those in the double inverse ("ultra") ETFs are less so, and even less so are the regular "inverse" ETFs. 

But the same thing can happen to any inverse ETF, and that's just not acceptable. 

Today, I Have a Better Way to Profit When the Market Tanks

Today, I want all of you Tycoons out there to start watching "Barclays iPath S&P 500 VIX Short-Term Futures ETN".  Okay, I've said a mouthful, haven't I?  The symbol is VXX.

What it does is attempt to track the movement of the CBOE Volatility index (VIX), which is a popular measure of the implied volatility of the S&P 500 index.

If you don't already know, the VIX is known as the "fear index".  It represents one measure of the market's expectation of volatility over the next 30 day period by tracking the price of out of the money options on the S&P 500.

Options get more expensive when people become fearful.  They get cheaper when people become more complacent.  People buy options to reduce risk, and that's why this trades the way it does.  It's like insurance rates going up when the insurance company thinks there is a bigger risk of something. 

For example:

If XYZ stock is at $10.00/share, and people don't think that XYZ stock will have much volatility in the near future, any given (hypothetical) XYZ option may be trading at $2.00.

But, if everything else were exactly the same (same time left before expiration, same strike price, XYZ stock still being at $10.00) except that there were a big story surrounding XYZ stock (such as waiting for an FDA approval on a major drug which could send the stock flying), the same exact option may be trading at $4.10 (instead of $2.00) because people are WAY more interested in playing the options to take a bet on XYZ's direction.

The premium of options on the S&P 500 won't go to zero.  VIX is not a company, it's an index.  It can't go out of business.  And VXX tracks the VIX.   

Take a look below at the 3-year chart of the VIX.  I highlighted the time period of the 2008 crash (September 2008 - March 2009), and while you'd be happy to own VXX if the market crashed like that again, I don't want you to expect to see that again for a long time. 

Below is a chart dating back to 1990.  You might notice that, even though the stock market was advancing fast in the mid-to-late 1990s, the overall movement in the VIX was also up.  This was because options contracts went up in price as investors speculated on stocks in addition to using them as a hedge for safety. 

You should also look at the period when the market came off the 2002-2003 bottom and rallied.  The VIX declined to extremely low levels (touching 10!) as the market advanced and investors became complacent.  

But the key is the fact that it has nice spikes that you are now able to trade by using this ETN.

Therefore, when the VIX is down and fear is low, it's a great time to get in.  It makes a great trade, and it makes a great long-term piggy bank that you can make deposits in a little bit at a time when investors seem to think nothing can go wrong. 

Look at the chart below of the S&P 500.  We have come a long way in a short time frame.  I can't give you the exact timing on this, but you should consider making it part of your arsenal.

Sure, you can buy it and see the market move higher and higher.  VXX would trade lower and lower as fear declined. 

Of course, you can be in the ETN and watch it lose value as the bull market continues higher.  But at some point, fear will always come back into the market.  That's one thing you can count on.  Therefore you can count on VXX spiking at some point.

So I'll ask you again:  Do you believe that, at some point in the next few years, investors in the U.S will be more fearful than they are today?

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