Don't get burned by your market hedgeMay 14, 2012: 5:00 AM ET
Products designed to track volatility may offer investors a way to profit if stocks fall. But there can be hidden risks.
By Janice Revell, contributor
FORTUNE -- Now that the S&P 500 index has racked up its best first-quarter performance since 1998 -- a 12% gain -- many prognosticators are warning that a nasty correction is looming. The good news is that there are new ways to hedge against a market meltdown. But tread carefully: An investment that looks like an easy way to protect your portfolio could actually make your losses worse.
Start with products linked to the Chicago Board Options Exchange Volatility Index (VIX), the most common measure of investor fear. The VIX measures the expected volatility in the S&P 500 index (SPX) over the next 30 days and generally moves in the opposite direction of the broader market. Indeed, the VIX plunged by more than 30% during the first quarter of 2012, hitting a five-year low during March. And if the market tumbles, the VIX is likely to soar.
That's why investors looking for a hedge have been piling into vehicles that track the VIX. The most popular is the iPath S&P 500 VIX Short-Term Futures (VXX), an exchange-traded note that has doubled in size over the past year and now holds about $2 billion in assets. The problem is that the VXX's returns can diverge dramatically from what investors expect. That's because it doesn't actually track the real-time, or "spot," VIX. Rather, its performance is based on a continually rolling portfolio of one- and two-month VIX futures contracts. Every day the note's managers must sell the expiring futures and replace them with new contracts that are typically more expensive -- a major drag on returns.
Worse still, you can lose money in the VXX even when the VIX itself is rising. That's been the case recently, as the cost to replace expiring futures contracts has been far above the long-run average, notes Goldman Sachs volatility strategist Krag Gregory. With the VIX still depressed, traders are anticipating a sharp jump soon and pricing it into futures contracts. During the last two weeks of March, the VIX itself rose by about 7% as the stock market rally began to waiver. But over that same period, the VXX actually declined 20%.
For a safer hedge, consider instead so-called protective put options. Put options give an investor the right to sell a stock at a preset price up to a predetermined date in the future, establishing a floor on potential losses. Low volatility makes option prices cheaper. And given the current VIX level, prices for put options on the S&P 500 are attractive right now, says analyst Chris McKhann of optionMonster.com.
Let's say you own the SPY (SPY), an ETF that tracks the S&P 500 and recently traded at $140 a share. If you wanted to limit your losses to, say, 10%, you could buy a put option -- at a cost of 80¢ a share -- that lets you sell the SPY anytime through June 16, 2012, for $126 a share. If the index falls below that price, you can still sell at $126. You won't score big gains using this strategy. But with portfolio insurance, that's really not the point.
--A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This story is from the May 21, 2012 issue of Fortune.