Trade the Volatility

One thing we can positively say about the markets recently is that they are extremely volatile.  Historically this has been an indication of a change in medium term direction; i.e., a bull or bear market.

I’ve talked in the past about how there are many risks to the market staring investors in the face -- debt levels, geopolitical events, QE, reserve currency issues are all reasons to build a wall of worry. And all of this uncertainty creates volatility.

Luckily there is a way to take advantage of these large market moves -- the CBOE Market Volatility Index, or VIX.

I won’t go into how it is calculated, but the VIX is a measure of implied volatility of the S&P 500 over the next 30-day period.  If it is trading at, say, 13, it means the expected swing in the market of approximately 13%.  Although the index is supposed to imply volatility in both directions, I have found over time that it actually tends to act as a “fear gauge” in the market (as it is often referred to).

If we are in a bull market, the VIX will typically trade lower as investors are expecting the market to keep rising and are becoming complacent.  When the market sells off, the VIX will rise.  How much depends on the ferocity of the selloff.

So how can you take advantage of these market swings we are seeing today?  For the trader looking to make money, I say use options on the VIX to trade the volatility. I typically feel more confident when putting on this trade when investors are very complacent.  There tends to be a floor on the VIX of low double digits -- somewhere between eleven and fourteen in my estimation seems to be a good entry point, depending on how aggressive you want to be.

When the VIX drops into this range, one can buy calls betting that the market will trade off and the VIX will rise. If you are expecting a large downdraft, you can buy options cheaper out of the money.  For instance, if the VIX is at 13, you can buy calls at a strike price of 15, betting on large move up.  This type of strategy can also be used to hedge a market selloff for your overall portfolio.

Be sure to leave yourself enough time for your thesis to play out.  Nothing is more frustrating than to have options expire just before a large move.  Playing the opposite trade, buying puts, is much more risky as the downside movement of the VIX can be limited, especially at low levels.

Buying options on the VIX is an aggressive strategy only for those familiar with options and short-term trading in general. The secret is being disciplined, having a plan, and sticking to it.

L. Todd Wood is a former emerging market bond trader.  His thriller novel, Currency, deals with overwhelming sovereign debt.