Here is an interesting speculative trade if you think stock market volatility is too low, or to put on a downside hedge against your stock portfolio, albeit indirectly. And one can do this by using options on the CBOE Volatility Index (VIX), namely a vertical VIX call spread.
The VIX provides a measurement of the implied volatility in broad U.S. equity 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 the VIX can be seen as an indicator of relative complacency. Some people call the VIX the fear gauge, 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.
As of Sept. 10, 2014, the VIX was trading at 13. It’s 52-week range is 10.28 to 21.48; this indicates that there is still a relatively high level of complacency in the market combined with a relative lack of fear despite all the recent global uncertainty (see “No fear”). Keep in mind that just last month the VIX was 17. Last November amid the government shutdown talks the VIX was in the low twenties; in November 2011 the VIX was trading at 40 and at the height of the financial panic in 2009 it touched 82! With the Dow Jones Index within 100 points of its all-time high as of this writing there is a good opportunity to put on a relatively inexpensive vertical VIX call spread.
If this market ever does go significantly lower (and it will one of these days) the VIX has the potential to go significantly higher. Given aforementioned global uncertainty there is a very good chance that volatility will return to the equity markets in a big way. And when that does happen it will be reflected in a large increase in implied volatility.
Rather than simply buy VIX futures or VIX call options outright let’s look at a hedged options spread with a very favorable risk vs. reward ratio.
We’ll look at the VIX October 15-17 call spread. This spread is trading at just 50¢ (long a VIX Oct. 15 call at $1.30 – short a VIX Oct. 17 call at 80¢ = 50¢ or $50 per spread), which seems mighty cheap to me, given the many October shocks we’ve seen over the years. A VIX at 17 or higher on the third Wednesday (VIX options expire on Wednesdays) of October will quadruple your money. And a VIX at 17 is hardly inconceivable given that it was there just last month. As in all vertical call spreads, the P&L graph looks like this:
If the VIX closes above 17 at expiration you make $150 and your ultimate risk, if the VIX doesn’t rise, is $50. Not a bad risk reward at 3 to1. The vertical call spread is 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 10 times at 0.50 and it goes to 1, 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 13 VIX will seem like a golden opportunity that slipped away.
Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Since 2006 Liss has educated and mentored traders.