Like a long-hibernating caterpillar finally emerging as a beautiful butterfly, many of my long-held picks like Sony, Advantest or Mitsui & Co. have rallied sharply in recent weeks. Not only am I overjoyed to be sitting on gains , but I m not in any rush to trade out of these strong, winning positions. As we often point out, the best indicator of markets is the price action itself. I ve lugged around many of these lesser-followed ideas for months. Now that they ve finally eclipsed multimonth highs, I m loathe to simply trade them away.

Yet I m also well aware that, ominously, there are signs of complacency creeping back into stocks. Investors recently polled by Bloomberg forecast gains in every one of the nine countries surveyed, the first time that s ever happened since the study began in 2007. The sentiment reading for the S&P 500 climbed to a near record, while those tracking Spain and Switzerland both reached all-time highs. Investors Intelligence review of stock-market newsletter writers showed a 53.4% bullish reading, the highest since December 2007 also a contrarian sign. Over the past 10 months, stocks haven t experienced as much as a 10% correction.

What to do? Rather than attempt to take profits and re-enter my positions at lower prices an improbable maneuver we discussed last year, I m instead looking to hedge some of my existing portfolio through volatility itself.
A 2009 Journal of Alternative Investments article demonstrated how adding a position in volatility through products like VIX options, notes or futures can help to boost and smooth return. For the 34 months ending December 2008, adding a 3% position in VIX call options helped boost an already diversified portfolio s return by nearly 3% while halving the portfolio s maximum drawdown.

A Good Call During the Collapse

Portfolio Performance With ATM VIX Calls March 2006 to December 2008

Source: VIX Futures and Options A Case Study of Portfolio Diversification During the 2008 Financial Crisis by Edward Szado, UMass Amherst Center for International Securities and Derivatives Markets
Note: E/B/A Portfolio = Diversified among stocks, bonds and alternatives.

Because options expire and must be rolled over, those interested in adding straight volatility might consider Barclay s iPath VIX Exchange-Traded-Note, which tracks the implied volatility of the S&P 500 through positions in VIX future contracts, less expenses. The note has demonstrated a striking -0.74 correlation to the S&P 500, meaning that when stocks drop the fund is almost certain to soar.

Of course, it is stocks that have soared in recent months, and as evidenced by a longer-term chart of the VIX, fear has now dropped to pre-crisis levels. What makes volatility a unique asset, however, is that unlike a stock, it can't go to zero. And when fear materializes, it tends to do so in rather dramatic fashion. The morning Dubai announced it would be skipping payments and extending maturities on its debt, the Dow Jones Industrials dropped more than 230 points, a fall of a little more than 2%. However, the iPath VIX ETN immediately leapt some 30%.

Nothing to Fear

VIX (CBOE Volatility Index) 2 years

These are unique products that most certainly are intended for more sophisticated and well-capitalized investors. But now that nearly every risk asset, from emerging markets to gold, tends to move in the same fashion, volatility products provide a unique hedge: a exposure uncorrelated with major markets that can help improve a portfolio s performance even with a relatively small position.

Now that bullishness is back, it s likely a lottery ticket worth picking up.

At the time of writing, Hoenig s fund owned many of the securities mentioned.