I would like to discuss today another way to hedge your equity portfolio against a major move lower, albeit perhaps indirectly. And we can do this by using options on the CBOE Options Volatility Index (VIX), namely a vertical VIX call spread.
The VIX is an index which provides a measurement of the implied volatility in the US market over the next 30 days. Remember that there are two sorts of volatility, historical and implied. Historical is just that, looking backwards. Whereas implied volatility is what the market in its wisdom of supply and demand thinks the volatility will be.
Higher volatility means higher options prices as larger swings are expected. Low volatility means little is expected in the way of market movement which is why I often think of the VIX as an indicator of relative complacency. Some people call the VIX the Fear Index as volatility tends to explode in falling markets and drop in rising markets. That means a good way to play an anticipated down move or hedge against such a move is to buy a VIX call spread.
Currently (September 3, 10:00 CDT), the VIX is trading at 16.50. It’s 52 week range is 11.05 – 22.72 and this indicates to me that there is still a relatively high level of complacency in the market combined with a relative lack of fear despite the recent downticks and global uncertainty. Keep in mind that in November 2011 the VIX was 40 and at the height of the financial panic in 2009 it touched 80! With the DOW up 89 points at this writing there is a good opportunity, in my view, to put on a relatively inexpensive vertical VIX call spread. Remember, if the market goes down the VIX will go up. And if the market really pukes the VIX will roar higher.
Let’s look at the VIX October 18-22 call spread. This spread is trading at 1, which seems cheap to me, given the many October Shocks we’ve seen over the years. A VIX at 22 or higher on the third Friday of October will quadruple your money. And a VIX at 22 is hardly inconceivable given that just a couple years ago it was 40.
I find this an interesting speculative trade as well as serving as a potential hedge against a down move. Don’t forget, if you do this as a speculative trade, that it’s always good to “take a double”. Meaning that if you buy this spread today ten times at 1 and it goes to 2, sell out the spread 5 times, giving you the other 5 for free. Every trader loves to play with the house’s money! Or, if using the spread as a hedge you can roll it over to the next month. The market will fall again sharply one day and when that day comes 16.50 VIX will seem like a golden opportunity that slipped away.
Thank you for reading. For more information, please visit my website: www.thelissreport.com.
Post-Publication Author Note: VIX Options expire on the the third Wednesday of October.
No positions in any of the mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.