This 'Fear Trade' Could Bring You 87% Gains

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This 'Fear Trade' Could Bring You 87% GainsBy Deborah O'Malley, StreetAuthority

With a slew of bad news recently hitting the streets, it appears fear is on the rise.

Unemployment rates remain high at 8.8%, housing sales are still sluggish and, despite an already weak U.S. dollar, the Federal Reserve is expected to keep interest rates near zero -- making the currency less attractive to outside investors.

On top of all this, on April 18, one of the most recognized credit-rating agencies, Standard & Poor's, lowered its U.S. debt outlook from "stable" to "negative." The downgrade means an increased likelihood the United States could lose its coveted "AAA" credit rating within the next two years.

The outlook was lowered because S&P believes the U.S. government isn't taking aggressive-enough action to reduce its massive debt load, especially in comparison to other debt-ridden countries.

Of the 17 countries deemed by S&P to have "AAA" status, the United States is now the only one to have a negative outlook -- a trend that could very well buck.

The notion that the United States could lose its credit rating has all-around negative economic implications. For starters, it means the cost of borrowing could increase. But worse yet, the U.S. dollar could lose its status as the world's reserve currency, causing a potential economic breakdown.

Fortunately, as a trader, there are ways you can benefit from these worries. As billionaire value investing guru Warren Buffet famously said, "be fearful when others are greedy, and be greedy when others are fearful." And by all accounts, now is a great time to be greedy -- with a reliable trading instrument.

But don't just take my word for it. Look to the Volatility Index (VIX) to make the call -- one of the best ways to assess objectively market fear levels.

The Volatility Index is calculated by the Chicago Board Options Exchange. The CBOE takes into consideration a number of trading factors to determine the market's volatility level. In essence, low volatility typically indicates traders feel calm and bullish about the market. But when bad news pushes the market lower -- as is currently happening -- trader fear tends to increase, along with bearish sentiment.

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To determine when market complacency and fear are at their height, fixed levels can be assigned to the Volatility Index (although these levels are historical and change from time to time). Generally, if the index is below 15, fear is relatively low. As the index rises toward 30, fear is increasing. And anything above 45 shows a strong level of fear.

After hitting a two-year low of 14.30 during the April 18 trading week, the index is currently hovering around 15-19. But the index appears as if it might rise, due to the recent S&P downgrade and other events triggering perceived economic instability.

Because the VIX cannot be directly traded, one way to profit from rising fear levels is to play the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ).

This ETN (exchange-traded note) targets mid-term four-, five-, six- and seven-month VIX futures contracts and appears to closely mirror the activity of the VIX. So when the VIX rises, so does VXZ, and when the VIX falls, so does VXZ.

VXZ currently trades for about $53.50 and carries an expense ratio 0.89%. The security has a market cap of about $5.6 million.

Technically, VXZ appears to be on the rise.

The index peaked at $104.32 in May 2010, following the "Flash Crash," which caused volatility and fear levels to spike.

As 2010 progressed into what many perceived as a bull market, fear subsided, causing the security to steadily drop to a two-year low of $51.61 in early February 2011.

Touching support near this level, the security quickly rose to a height of $65.04 in early March, as tensions in the Middle East escalated, causing fear to rise.

Testing a shelf of resistance near $65, the security fell to around the $55 as traders tuned away from the Middle Eastern conflict.

However, during the April 18 trading week, on news of the S&P rating downgrade, VXZ jumped once again -- this time breaking resistance marked by the Intermediate downtrend line. The break of this trendline is significant, as it suggests the security could once again be on the rise.

VXN has pulled back during this April 25 trading week. But if the security again tests and breaks the trendline, it could very well move to nearby resistance at $60.05. If VXN were to test and break nearby resistance at $60.05, the security could easily soar to around $75 before encountering any substantial historical resistance.

The major downtrend line currently intersects at this level. Should VXZ break the Major downtrend line, the security could rocket to the $100-range -- a level it hit nearly a year ago.

If the security were to once again reach the $100-range, traders tuning in at current levels could make a hefty profit.

Action to Take:
Recent economic events, especially the S&P rating downgrade, appear to be reigniting fear. The VXZ security provides a great instrument to potentially profit from rising fear levels. The recent pullback provides an attractive entry point. Traders taking a position now could potentially make returns of up to 87%.

Disclosure: Neither Deborah O'Malley nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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