Daily Stock Market Equity and Options Trading Commentary

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Saturday, June 6, 2009

Market Stabilizing or More Volatility Ahead? 3 Strategies to Hedge against Volatility

With the VIX closing below 30 (historically high level) as of Friday June 5, 2009, it looks as if the market is starting to settle down. The VIX shot above 30 on September 15, 2008 and has stayed above it (closing value) ever since. The VIX closed below 30 three times in May; on the 19th, 20th, and last trading day the 29th. As for June the VIX closed below 30 on the 2nd, but broke back above 30 on June 3rd before finishing the week below 30.

This seems to be a similar trend, and by the looks of it the VIX does not want to stay below 30. I think if we can stay below 30 and eventually move lower, it will attribute to the overall confidence in the market, and push the market higher. Looking at the chart below, we can see that the last time the VIX closed below 30 was on September 12, where it closed at 25.66, this correlates to the S&P 500 at 1251.70. (click image to enlarge)

I am not saying that the next time the VIX is at 25.66, the S&P 500 will magically be at 1270. However I am stating that it should attribute to a market rally. The chart above shows the VIX (red and white) and the S&P index (green), and as you can see is almost perfectly negatively correlated. As the VIX gets higher the market sells off, and as the VIX drops the market rallies (this should make sense).

Historically entering the summer months the market does not perform as well as the other months, however if the VIX could stay below 30 and get lower, it may help to keep the rally going into fall.

However something very different happened on Monday June 1, 2009. With the market rallying near 2.6% on Monday, we’d expect the VIX to sell off correct? Incorrect, the VIX also rallied 3.9%. This is a major disconnect from the way these two have been correlating in the previous 6 months. We can see from the 10 day chart below. (click image to enlarge)

This sends a signal to me that the market is factoring in more volatility ahead. Some ways to hedge against volatility are outlines below.

Strategy 1: Purchase the iPath S&P VIX Short-Term Futures ETN (VXX)

Strategy 2: Purchase the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)

Both of these are ETN’s and will help hedge your overall portfolio against volatility. As you can see from the chart below both ETN’s track the VIX quite well (VXX in green, and VXZ in blue). (click image to enlarge)

However I prefer using a bit riskier strategy with options. This captures the actual move of the volatility or “fear index”.

Strategy 3:

One way I hedge against volatility is to purchase call contracts on the VIX. Friday I used the weakness in the VIX to open a 35/40 option spread (learn more about options here) for the August expiration. It was $160 per contract to open this position, and I am protecting my portfolio against the VIX spiking. This may seem like a stupid idea, but let’s not forget those days back in October where the market sold off tremendously and the VIX spiked. Currently the options market is factoring in a 29.1% chance the VIX is at or above 40 come August expiration.

Using options to predict the probability the VIX is below 30:

As posted on my blog about VIX options, we can see that the options market is factoring in a 51.7% probability the VIX closes at or above 30 by June expiration (all data as of close Friday June 5, 2009). If we go out to July the options market is factoring in a 56.8% chance the VIX will be at or above 30 at July expiration.
Disclosure: Long VIX July 35/37.50 call spread, VIX August 35/40 call spread

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chris.mckhann said...

Curious what you are using to give "51.7% probability the VIX closes at or above 30 by June expiration"

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