Sell in May and Go Away? 2 Ways to Play

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Is the bull market running out of steam? Let’s face it — it is aging. We are now just over five full years since the generational low in March 2009. The trading in 2014 has been somewhat frothy. No strong moves to the upside or downside. We have moved in a defined range, trading on jobs news, earnings, and the Federal Reserve’s announcements. On Friday morning, we had a tremendous jobs number, with non-farm payrolls coming in at 288,000 jobs added, crushing consensus estimates of 211,000. Yet, the market reaction at the time of this writing is stagnant.

To see such a muted reaction in trading after this strong piece of data is concerning. In fact, I argue it is setting up for the old “sell in May and go away” mantra. For those unfamiliar, this is where a lot of traders sell and move their cash to the sidelines for the traditionally low-volume summer season. Vacations, barbecues, and holiday celebrations take precedence over trading. It generally leads to a decline in share prices in the summer months. Coupled with the fact that we still have not had a greater than 15 percent correction, this particular May could spell trouble.

To take some protective action, traders may want to put on some bearish positions. Those who are bearish could consider selling stock, selling covered calls on their positions, shorting stocks, or buying puts. While each of these approaches has its respective benefits and risks, in this article, I want to highlight several funds that could provide great short-term returns in the event of a market selloff.

These types of funds performed terribly in 2013, as the market saw up-day after up-day as well as record low volatility. However, substantial gains can be made in these high liquidity, high market cap/net value names.

1. iPath S&P 500 Short-Term VIX futures ETN (NYSEARCA:VXX)

The VXX is a tool that tracks the Chicago Board Options Exchange Market Volatility Index, or the VIX, which is a popular measure of the implied volatility of the S&P 500 market index. The VIX is a measure that is supposed to represent the market’s expectation of stock market volatility over the next 30-day period. The VXX is a fund that is one of the better ways to track the VIX (which is not directly available to invest in) than many of the other leveraged volatility ETNs.

Leveraged volatility funds, including the VelocityShares Daily 2x VIX ST ETN (NYSEARCA:TVIX), are to be avoided, as they tend to lose value rapidly due to contango. Information regarding this conundrum in leveraged names due to rebalancing of the portfolios can be found here. These should be avoided, as TVIX has lost over 94 percent of its value in a few short years.

The VXX as an investment seeks to “replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 index at various points along the volatility forward curve.” As part of this approach, the index futures roll continuously throughout each month, from the first month VIX futures contract into the second month VIX futures contract.

While volatility has not been an attractive play of late, it has been gaining steam. The VXX recently underwent several splits to increase share value, as the value of the investment vehicle has plummeted in this aging bull market. The fund has an annual expense ratio of 0.89 percent and is currently trading at $43.93. It has a 52-week trading range of $43.65-$61.03 (please note this range does not account for shares reverse splitting). Expect volatility to spike this May as traders sell to “go away” and thirsty investors on the sidelines seek bargains in this market.

2. Direxion Daily Small Cap Bear 3X Shares (NYSEARCA:TZA)

This is my favorite way to invest in a bear market short-term, as it is a high-liquid net value play relative to smaller plays. However, it is not for the faint of heart, given its leveraged nature. The contango issue is at play here. If the market does not move, this trading vehicle will slowly lose value. How does the TZA differ from VXX? Well, it is not a direct play on volatility. TZA management seeks daily investment results of 300 percent of the inverse of the price performance of the Russell 2000 Index, which tracks small cap stocks.

It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. TZA actually does not invest in equity securities or stocks. What TZA does is creates short positions by investing at least 80 percent of its net assets in financial instruments to provide leveraged and unleveraged exposure to the small cap index, and the remainder in money market instruments. TZA, like the VXX, has also undergone reverse splits in response to the bull market powering ever higher. It currently trades at $17.10 per share on average daily volume of 10.9 million shares. TZA has a 52-week range of $14.31-$38.51.

Conclusion

There is nothing wrong with profit-taking. It is OK to sell in May and go away if you so choose. The facts are that market sentiment is worsening, but we don’t need to dump positions all at once here. Everyone seems to be expecting a selloff at some point, and a large correction could be brewing under the guise of “sell in May and go away” fears. I recommend these two funds that do incredibly well during corrections. It is not uncommon for these vehicles to return double digits in a few short weeks if the entry point is timed well. On the whole, they serve as strong hedges in a well-balanced, diversified portfolio.

Disclosure: Christopher F. Davis holds no positions in names mentioned in the article. He is net neutral on TZA and VXX, and cautions investors to do their due diligence before making any decision to buy or sell any securities.

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