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Volatility ETFs to Consider During the Calm Before a Storm

As the markets push toward new highs and grow more complacent, investors may want to take a look at exchange traded funds that track the CBOE Volatility Index to hedge potential risks ahead.

The VIX, or so-called fear index, is a widely observed indicator for investor sentiment in the stock market and measures the expected or implied volatility of large-cap stock options traded on the S&P 500 index. Exchange traded products that track VIX futures allow investors to profit during rising volatility or hedge against short-term turns.

Related: ETFs to Hedge Against a Turn in a Complacent Market

For instance, as the S&P 500 dipped 0.5% on Monday, the VIX jumped 12.4% to 13.51, which is still around its lowest level for the year.

Traders also be looking to VIX-related ETPs as a means of hedging market risks. On Monday, the iPath S&P 500 VIX Short Term Futures ETN (VXX) gained 1.6%, ProShares VIX Short-Term Futures ETF (VIXY) rose 1.5% and the leveraged ProShares Ultra VIX Short-Term Futures (UVXY) increased 3.2%. VIXY also saw trading volume surge to 5.7 million on Monday, or close to eight times its average daily volume.

Mohamed El-Erian, chief economic adviser to Allianz and chair of President Obama’s Global Development Council, warned of potential “jump conditions” in light of potential points of weakness and uncertainty around the globe, such as fragile Italian banks, political risk in Turkey and vulnerability to lone wolf attacks.

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“These issues share a potential for fuelling so-called jump conditions in which there is a leap to a different set of circumstances, rather than a smooth and incremental evolution,” El-Erian wrote for the Financial Times. “In turn, they could change longstanding economic and financial relationships, impact the way economic agents interact with each other, fuel political anomalies and, in the case of unusual asset class correlations and valuations, undermine some of the institutions and basic tenets of the capitalist system.”

Looking ahead, El-Erian warned of other potential jump conditions, such as the October referendum in Italy that could complicate European politics after the Brexit vote, a November presidential election in the U.S., a transitioning economic model in China that has created some hiccups along the way and a money-fueled world where central banks have brought us deeper into uncharted waters.

Related: VIX, Bearish S&P 500 ETFs to Hedge Uncertainty

However, El-Erian argued that markets remain relatively calm, with investors jumping on any drawdowns with a “buy on dips” mentality, especially as it has been a winning trade since the financial downturn. Moreover, investors lack any attractive alternative.

“It is understandable for markets to trade on the current reality of cash flow and put aside, at least for now, the possible consequences of the ever growing gap between investor behaviour and a growing list of unusual economic and political uncertainties,” El-Erian added. “In the process, however, a cocktail is brewing that risks future financial volatility and jump conditions in various market segments.”

Consequently, El-Erian advises investors to lower expectations, expect increased volatility, combine higher cash allocations with greater exposure to alternatives and become more tactical.

Click here to read the full story on ETF Trends.

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