There's no doubt 2015 was one of the most volatile years in recent history.
But here's the thing... I believe 2016 could be even rougher.
We haven't even seen the sell-off I'm predicting yet; it's likely to make the plunge we saw on Aug. 24, 2015, look like a kiddie ride.
Just as there's nothing solid or healthy underpinning the stock market gains we're seeing now, there will be nothing to catch investors who aren't prepared to trade this volatility - just a long, deep drop.
There's no bottom in sight, but the good news is there's one easy way to trade just about everything the market is likely to throw at you this year.
Here's what we should do...
When I'm bearish and want to bet stocks are headed lower, I generally like buying inverse exchange-traded funds (ETFs) based on the major market indexes.
ProShares Short Dow 30 (NYSE Arca: DOG) for the Dow Jones Industrial Average, ProShares Short S&P 500 (NYSE Arca: SH) to short the S&P 500, and ProShares Short QQQ (NYSE Arca: PSQ) to bet the Nasdaq is headed lower.
If I'm extremely bearish, and I believe stocks are going to fall hard today or tomorrow, I'll sometimes buy a leveraged short inverse ETF like the ProShares UltraPro Short S&P 500 (NYSE Arca: SPXU). The UltraPro Short S&P fund is a "3x leveraged" inverse ETF. That means if the S&P 500 goes down 1% today, SPXU would go up 3% today.
But this is important: Leveraged ETFs are only meant as short-term trading vehicles. That's why I said "if I believe stocks are going to fall hard today or tomorrow." Because of the way leveraged ETFs are priced, they're "re-set" every day - they're not good long-term holds.
In a perfect world, if your conviction is right and you buy a leveraged inverse ETF and stocks go down right away, and they keep going down for multiple days in succession, you'll be a very happy camper.
I'm not greedy. If I have a straight run for a few days holding an inverse leveraged ETF, I'd take my profits as soon as I think the sell-off is over.
I wouldn't wait another day, I'd ring the register and be happy. If I own an unleveraged inverse ETF like DOG, SH, or PSQ, I'd probably use a 5% to 10% stop to get out if the markets rallied. If you take small losses, you can get out and figure out where stocks are going and get back in if your timing was off but you think they're going down again.
Now let's look at one of my favorite plays: money...
There are lots of leveraged gold ETFs. Here are some of my favorites. Just remember what I said about holding any leveraged ETF: they're very short-term trading vehicles.
Another way to "leverage" gold on the upside (betting bullion is going higher) is to buy miners. Mining stocks move up a lot faster than gold itself in an up-trending gold market.
Currencies are a little bit different, but it's not hard to trade their moves up or down. Don't forget, you can't just short one currency - all currencies are "priced" in terms of another currency, so they always trade as a "pair."
If you think the euro is going down relative the U.S. dollar, you can actually sell short the CurrencyShares Euro ETF (NYSE Arca: FXE). If you want a leveraged (2x) way to bet the euro is going down relative to the U.S. dollar, you can buy a popular inverse leveraged euro/dollar ETF, the ProShares UltraShort Euro (NYSE Arca: EUO).
There's another popular way to hedge and play downturns in the market, but it's trickier than it looks. Still, done right it can lead to some big profits on the short side.
I've got nothing against VelocityShares Daily 2x VIX Short-Term ETN (NYSE Arca: TVIX), if you get into it and the move you expect, a dramatic drop in prices and a spike in volatility, happens right away.
But here's that tricky part I mentioned.
[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
It's a leveraged ETF - so if you don't get a sustained move down pretty soon after you buy it, and you sit with it a few weeks, or worse, a few months, it loses its value quickly. Bottom line, it's a leveraged ETF and great if you get the timing right, get in, and get a sustained move in your direction. I'm not a huge fan of the iPath S&P 500 VIX Short-Term Futures ETN (NYSE Arca: VXX), either, because it's based on VIX futures.
VXX is thought of as an ETF, but it isn't. ETFs have their own supply and demand dynamics and their own bid-ask spread dynamics. But it's based on two sets of futures that have their own "valuation" dynamics based on rolling first- and second-month futures contracts.
VXX is actually an exchange-traded note (ETN), not a fund. It's actually a derivative, which adds up to a lot of moving parts and is hard to arbitrage and "value" properly.
But if you're going to use VXX, I'd suggest you add a one-quarter dose of it to whatever other protection you have on. Just keep in mind, if markets settle down and stocks flatten out and go sideways, the VIX and VXX will drop a lot quicker than non-leveraged inverse ETFs you might have on for protection.
My favorite way to play a spike in volatility is to buy calls on the actual VIX.
When I'm playing options, I generally like to buy options three to six months out. I always prefer further out options because it gives me more time, but you have to weigh the time against the higher price or premium you have to pay for them.
That's why I look three to six months out and incorporate how much volatility I expect over that three to six months. If I expect a spike in volatility sooner rather than later, I'd opt for the cheaper, near-term options. If I run out of time but I still think I'm right, I'll roll into the next three months out options.
In a perfect world, if you knew the move you expected was going to happen in a couple of weeks and last a week or two, you wouldn't waste money buying further out options and pay for time you wouldn't need.
But... it's not a perfect world and I'm very often right, but I can get stung because my options expire and I hesitate rolling out to the next few months and get sick when the move I expected all of a sudden happens and I'm not in the trade. That's the worst feeling in the world, but you won't have to sweat it with this strategy.
Hope you have a great holiday.
Follow Shah on Facebook and Twitter.
