How can you profit or hedge yourself against a potential large down move short of exiting the market completely?
Buy a VIX vertical call spread as a speculative trade or downside hedge.
A vertical call spread on the Chicago Board Options Exchange volatility index (VIX) is a trade that can be a speculative play betting that option volatility will increase, a hedge against a stock portfolio, or both.
The VIX is an index that measures the implied volatility of the U.S. equity market, based on S&P 500 options, in 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 collective wisdom of supply and demand thinks the volatility will be.
Higher volatility means higher option prices as large swings are expected. Low volatility means that little is expected in the way of market movement. Some people call VIX the fear gauge as volatility tends to explode in falling markets and drop in rising markets. That means a good way to trade an anticipated down move or hedge against such a move is to buy a VIX vertical call spread. Let’s start by looking at the P&L graph of a simple vertical call spread:
As of April 2, 2014 (11:45 CDT) the VIX is traded at 13. Its 52-week range is 11.61 to 21.91 (see “Measuring fear,” below). This indicates that there is a relative lack of fear in this market that borders on downright complacency. Just last September, the VIX was over 20 and at the height of the financial panic in 2009 the VIX broke 80!
More importantly, the VIX tends to stay extremely depressed for only so long before it offers at least a token increase above the relatively mild level of 20. The VIX experienced four of these mini-spikes in the last 16 months.
With the Dow Jones Industrial Average up seemingly every day (at least until April) there is, in my view, a good opportunity to put on an inexpensive vertical call spread. Remember, if the market goes down the VIX will go up. And if the market really pukes the VIX will explode higher.
Let’s look at the VIX June 16-20 vertical call spread (above). You can buy the June 16 call (strike A on the graph) and sell the June 20 call (strike B) for a debit of just 80¢ ($80 per trade, plus commissions). A VIX higher than 20 in June quadruples your money. And a VIX higher than 20 is hardly inconceivable considering it was 21 just last September.
This makes for a compelling risk/reward ratio—80¢ risk to make $3.20—as well as a hedge against a down move in the stock market.
Believe it or not, the market will fall again sharply (as it has in the first part of April) one day and when that day comes a VIX of 13—or even 17, which it touched on April 15—will seem like a golden opportunity that slipped away.
Randall Liss is a veteran of the exchange traded options industry. He helped found the European Options Exchange in Amsterdam in 1978 (now part of Euronext). He traded as a market-maker on the floor of that exchange from 1986 until the trading floor closed. He is a co-founder of The Market-Makers Association. Since 2006 Liss has devoted his energy to educating and mentoring traders.