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Sunday, August 9, 2009

Trading the Volatility Index (VIX) A Bearish Approach

Lately I've been paying a lot of attention to the CBOE Volatility Index (VIX). The VIX traded lower by as much as 6.58% Friday before rebounding slightly and closing down 3.54%. Historically as the market moves lower the VIX moves higher, and vice versa as you can see from the 1 year chart below (click chart to enlarge).

I believe the market may be due for a short term sell off as earnings season comes to an end, so one way to hedge your overall portfolio (as well / instead of selling covered calls on stocks like mentioned in Sell Off Ahead? 25 Ways to Profit & Protect from a Stock Market Correction) is to trade options on the VIX. I believe the VIX at 30-35 isn't out of the question, as we all know the U.S. economy just isn't out of the woods yet. If increased levels of uncertainty return back to the market in Q3 or Q4, I expect to see the VIX at 35 or higher. A one week chart of the VIX and S&P, from the early July sell off, is below.

As you can see, as the S&P 500 sold off by almost 5%, the Volatility Index spiked by nearly 20%. So in this post I will outline an option strategy that will profit if the market sells off. This post requires the knowledge of stock options. To learn more about the risks, pricing, calculations, strategies, and options in general click here. The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares.

VIX Option Strategy: Opening a diagonal call spread on the VIX. I am opening this position using the December 25 call options on the Volatility Index for my base. The current options market is pricing the December 25 Call on the VIX for $510 per contract. Once I have purchased the 25 calls, I'll wait for a spike in the Volatility Index, and write out a higher strike / closer expiration call option.

For example, let's say I purchase the December 25 calls on Monday August 10, 2009 and the VIX spikes to near 27 by Wednesday of the same week. I would most likely choose to write my contracts out for the August 32.50 Strike call option (which are currently trading at a theoretical price of $25 per contract). I assume the contract price would increase to roughly $75 per contract on such an increase. This would lower my cost by almost 15%. If the VIX is above 32.50 at expiration this position would profit 72.4%. If it is not above 32.50 at August expiration, it can be written for the September options expiration. I will continue to do this until I am called out. If the VIX keeps declining and higher strike options are not written, this position will lose 100% of the price paid for the December 25 calls, but again it is a portfolio hedge so it can be seen as a cost of doing business.

The periods just before expected economic data, like monthly unemployment numbers, make for a great time to write out the higher strike call options. This is because the Implied Volatility spikes leading up to the data, which results in a higher contract price. After the data is released the implied volatility drops, many times resulting in a decrease in the contract price, even as the VIX increases toward the higher strike price.

This is one way to hedge your portfolio and possibly a way to create monthly income depending on where the Volatility Index trades in the months to come. If you are bullish on the market I would look to be purchasing at the money Put options on the Volatility Index, as they are priced very low.

This is just an example and not a recommendation to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

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