One of my primary goals is to invest where I have an objective edge.   There are many ways to try to get an edge, the two most common being:

• Value investing—where you try to find companies that are currently undervalued, or likely to  grow their profits faster than expected
• Technical analysis—where you use patterns or indicators to determine what a security will do next (e.g., head-and-shoulders, oversold / overbought)

Both of these approaches, in their standard usage require you to correctly predict a future price.  In June 2011 UBS introduced two new ETNs that get their edge by predicting that the traditional price differentials in futures contracts will be stable.  See this post (http://tinyurl.com/7f8fn3t) for details.  In theory these ETPs are not sensitive to the absolute price of the products (oil and natural gas)—they just need the term structure of the futures to stay close to their historical norms.

After six months that produced dramatic price moves in oil and natural gas, these funds are demonstrating they are insensitive to the commodity prices, and GASZ is showing a tidy 10% profit.  The charts below show the performance of OILZ and GASZ compared to popular ETNs that try to track the price of these commodities (USO & UNG).

Natural Gas: GASZ vs UNG

It looks to me like GASZ is a winner. The jury is still out on OILZ.  The price spikes on the charts are probably due to investors buying or selling when bid / ask prices were especially wide.  These products are lightly traded and require some research in order to set appropriate limit orders.

Disclosure: long positions in OILZ and GASZ

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Since the CBOE’s introduction of Weekly options, our opportunities to take advantage of expiration day dynamics have quadrupled for many stocks/indexes.  Depending on your position, it is fascinating/horrifying to watch the premium collapse on options in their last couple hours of trading.    Jeff Augen in SFO weekly has written an interesting article (New Approach to Trading on Expiration Day) on some of the underlying mechanisms behind the last day dynamics.

He points out that when a stock moves above a strike price (e.g., 380 for AAPL) on expiration day, covered call writers with just now in-the-money calls are motivated to close out their positions, as well as those long the calls.  The bid price on the options can be low enough that large scale option holders often prefer to exercise their options and sell the stock to close out their positions.   The combined selling pressure from these processes can mute, or even reverse an upswing in a stock.

There are quite a few conservative investment strategies that deliver a good return if the underlying security doesn’t move much.   Covered calls and dividend collection are two that come to mind.   These strategies are conservative in the sense that they don’t require the security to go up in order to be profitable—in fact a stable price is just fine.  However, if the market tanks, both of these approaches can subject the investor to big losses that far outweigh the profits they offer.   Investing in volatility is an attractive way to hedge away this downside risk, because volatility usually goes up when the market goes down.   Usually is the operative word.  These last two weeks were an example of when this correlation fails.

Hedging the S&P with volatility, click to enlarge

The chart above tracks percentage changes since the first of December for SPY and two popular measures of volatility, the non-investable VIX, and VXX, which is one of the most popular ways to go long volatilty.  SPY ended up down 2.7% and both volatility measures went down over this period—a lot.  Not much of a hedge.  I’ve included the nearest two months of VIX volatilty futures to show that it is not just contango that is driving VXX down, the underlying futures dropped too.

One volatility ETN didn’t drop.   Not only did XVZ, Barclays’ Dynamic VIX fund go up, it went up about the same percentage as SPY went down—2.5%.

Hedging S&P --XVZ?, click to enlarge

XVZ has only been around since August 18, 2011 so our price history is pretty limited. The chart below shows the results of investing $1K each in SPY and XVZ, SPY and VXX, and $2K in just SPY.

$2K investment since Aug-11, click to enlarge

The SPY+XVZ combination is noticeably less volatile, with a standard devation one third of the others: 22 vs 75 and 78.   However five months is a really short time to judge a strategy like this, so I expanded the backtest a little, back to January 3, 2011 using my XVZ simulation.

XVZ hedge for S&P 500 through 2011, click to enlarge

This chart illustrates two other characteristics of XVZ.  It is designed to capture big volatility jumps, like the one in August, and hold onto them once they occur. And it too suffers from contango (first half 2011)  if it is severe enough—although it was minor compared to what happened to VXX.

Clearly XVZ is not a perfect mirror of the S&P 500, but its behavior when volatilty spikes makes it even more attractive than a pure hedge. Market panics are not predictable, and having a workable hedge that turns a panic into an opportunity is intriguing.

SPY went ex-dividend Friday the 16th, so it is too late to buy the security and still receive this quarter’s dividend.  The dividend payout will be $0.7701 per share on January 31st, 2012.  Yes, SPDR is in no hurry to distribute the  $530,000,000 (!) in dividends that it collected last quarter for SPY.

For more information about SPY’s dividend and its sister ETFs IVV, and VOO see this page.

For general information about dividends (e.g., interactions with stock price, their interactions with options) see  Top 10 questions about dividends.