The Easiest Way to Profit from Fear

Will it ever end? It seems like one day the Dow Jones Industrial Average swings up +200 points and then gaps down -300 points the next. Several weeks of that is enough to make most investors nauseous.

But a simple change in attitude can fix all of that.

You’ve heard the adage “be greedy when others are fearful.” There’s a way to do just that.

But first, let’s take a look at just exactly how fearful investors really are. We do this by looking at the Volatility Index (VIX), also known as the “Fear Index.”

The Volatility Index is based on data collected by the Chicago Board Options Exchange. Each day, the CBOE calculates a number based on prices paid for puts and calls for the S&P 500. This number gives traders an idea of the implied volatility in the market for 30 days.

A VIX reading above 30 generally means the market is relatively volatile and investors are fearful, while anything below 20 implies a period of low volatility and a calm sentiment among investors. Keep in mind that the index is a contrarian sentiment indicator. If either of these levels is breached, traders look for a turnaround in the market.

With that information in hand, a look at the chart below says it all.

Remember: the Volatility Index is a contrarian indicator. Markets usually turn when the index fluctuates to one extreme or another. And while the index has spiked, we’re still well off the elevated levels of volatility we experienced during the financial crisis. During that time, the VIX broke 80.

As a result, it took a long time to get below 20. As soon as it did, markets tanked and volatility spiked, leading to a roller coaster May.

So what’s next? Well, the market is still behaving like an angst-ridden teenager right now. It’s calmed down a bit (the VIX is hovering around 30 right now), but we’re still not in normal territory yet. Investors are still anxious over the European debt crisis, the BP (NYSE: BP) oil spill and high unemployment in the United States, among other things.

These aren’t facts investors probably didn’t already know and these problems have had a bad habit of lingering for longer than what many expected. There’s no reason to think they’ll go away any time soon, so the best we can do is try to figure out how to make a little money from this. And besides, investors seem just jittery enough to send stocks plunging on the next piece of bad news anyway.

If you think we’re in for more volatility down the road, then the iPath S&P 500 VIX Short-Term Futures (NYSE: VXX) ETF makes a lot of sense as a portfolio hedge. As Nathan Slaughter, Chief Investment Strategist of StreetAuthority’s ETF Authority, puts it, this fund is literally designed to profit from fear itself.

Action to Take –> VXX holds rolling first and second month futures contracts, so investors need to keep in mind that it won’t track the VIX perfectly. And investors will need to be cautious — the market can turn on a dime and this isn’t the type of holding to have when things cool down. But if you think fear will continue to rule the market, then VXX looks like a good bet.