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How to Cash in on the Crash of VIX:

Last week, VIX fell to as low as we have seen in four years.  I believe this has created a short-term buying opportunity.  Option prices (volatility) should be headed higher (in my opinion). 

How to Cash in on the Crash of VIX:  

As most of you know, VIX is the volatility measure based on option prices of the S&P 500 tracking stock, SPY. Last week, it had fallen all the way to 15.45, about the lowest level we have seen in several years. 

VIX is the so-called “fear index,” and historically has moved higher when there was uncertainty (or lower stock prices) in the market.  Back in 2007, a VIX this low was probably appropriate.  The stock market had been on a slightly-upward flattish direction for many months, and there was little unrest in our domestic economy or around the world.  In 2008 when markets imploded, VIX rose as high as 80.

Today, there seems to be uncertainty all over the place.  Some people are talking about the possibility of a double dip recession, while others focus on escalating oil prices, high unemployment, and most of all, a melt-down in several European countries that might have a domino effect on our economy.

So where has all the market fear gone?  There are a huge number of uncertainties in the current economic world, both at home and abroad, and the market seems to be ignoring them. 

Over the years, VIX has shown a strong inclination to revert to the mean, and the mean is 20.54.  I think it is inevitable that VIX will climb back up toward, or above, 20 in the near future.  If this is the case, how can you benefit from it?

A Time to Buy VXX? This stock (actually an exchange-traded note, ETN) is highly correlated to VIX.  It is based on the futures of VIX which are generally closely related to VIX.  It closed yesterday at $13.20, the lowest price in quite a long time.  About six months ago (when VIX was in the 30’s), VXX traded in the low $40’s).

On one hand, I believe that it is highly unlikely to go much lower, and on the other, I expect that some unforeseen event will surely come along at some point to spook the market and send VIX and VXX sharply higher.

There is one serious shortcoming of owning VXX, however.  Due to the way it is constructed, something called contango reduces its value every month that the futures for VIX remain unchanged.  For this reason, the only time that it is a good idea to buy VXX is when VIX is unusually low (and there are reasons to believe that it is headed higher).

An ETN that benefits every month from contango is the inverse of VXX.  It is called XIV (the inverse of VIX).  Last October, when XIV was trading about $6.70 (and VIX was in the 30’s), I made a major investment in VIX (and made an impassioned plea to my subscribers to do the same).  Now that VIX is less than half what it was then, last week I sold most of my holdings for more than $13, almost doubling my money over that period.  With VIX so low, I believe that there is a better chance that XIV will suffer from a rising VIX than there is that it will benefit from the contango tailwinds that it usually enjoys.  (When VIX moves over 20, I will probably buy XIV once again).

On last Friday when the market fell by almost 1%, VIX rose from 15.45 to 16.27 (5.3%) and VXX rose from $12.55 to $13.20 (5.2%) to give an idea of the potential gain for VXX if option volatility moves back to its mean average of 20.54.

Another way to play VXX is to buy the stock and write a call against it, or at least against some of it.  With VXX trading at $13.20, an August 14 call could be sold for $.74 which would give you a 5.6% gain for one month if the stock doesn’t change, or an 11.6% gain if it closes above $14, the call you sold is exercised, and you lose the stock.  Either scenario does not seem so bad for a single month. 

The key assumption here is that VXX is quite unlikely to trade any lower than it is right now.  I believe that this is a reasonable assumption to make.  While it might trade lower temporarily, history says that it won’t stay down there for long.

VXX has been recognized as one of the best hedges against a falling market.  Some analysts have stated that a $10,000 investment in VXX will protect a $100,000 market portfolio of stock (although my estimate is that it would take about a $25,000 investment to accomplish that).  Once again, however, because of the contango issue, when VIX is at or above the mean of 20.54, it is generally not a good idea to buy VXX unless you strongly believe that uncertainty, and option prices, are headed higher.

In any event, I think VXX is a good short-term buy right now as a bet that option volatility will rise as things in Europe start spooking the market once again (in spite of the contango issue that will depress its value somewhat).

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