VXX tracks the first and second month VIX futures contracts

http://www.bloggingstocks.com/2010/05/17/make-money-when-volatility-spikes-vxx-vxz/

If I were to choose one word to describe the stock market for the past few weeks, it would be volatile.

Sometimes, a volatile stock market can be a bullish thing, but most of the time -- like during the past few weeks as we've seen 10% drops in the Dow -- volatility equals bearishness.

But investors can make money when volatility increases by trading one of the iPath exchange-traded notes (ETNs) that track the CBOE Volatility Index (VIX). The trick is choosing the right one.

The iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) both track volatility in the market by following the values of various VIX futures contracts, but the VXZ gives you a lot more bang for your buck than the VXX if you're looking to hedge part of your portfolio and make money when volatility levels jump.

While both ETNs react well and can make you money when volatility increases, the VXX typically loses more value than the VXZ when volatility begins to decline, which makes it a less effective hedge. Here's how it works:

The VXX tracks the first and second month VIX futures contracts -- the futures contracts that are going to expire within one to two months -- while the VXZ tracks the fourth, fifth, sixth and seventh month VIX futures contracts. Because the VXZ tracks futures contracts that aren't going to expire for four to seven months, it tends not to lose as much value during periods of low volatility because futures traders still have to price in more uncertainty in futures contracts that aren't going to expire in the near term.

Because a VIX futures contract that expires in seven months is almost always going to be more expensive than a VIX futures contract that expires in one month, the VXZ is almost always going to be more expensive -- and hold its value better -- than the VXX.

Just looking back one year to May 2009, the VXX has dropped from a high of $89.59 to its current price of $26.86 (a loss of 70%). During that same time, the VXZ has dropped from a high of $101.59 to its current price of $82.55 (a loss of only 19%).

So if you're looking for a nice volatility hedge and a great way to make money when the VIX spikes, consider choosing the VXZ over the VXX.

Disclosure: I do not currently own the VXX or the VXZ.