VIX is a measure of the average Implied Volatility of SPY, the tracking stock of the S&P 500. It is often referred to as the "fear index." When investors get scared, they often buy put options and/or sell call options to protect themselves against a big market drop. When this happens, VIX (and option prices in general) usually moves higher.
At Terry's Tips, we use an options strategy that consists of owning calendar spreads at many different strike prices, both above and below the stock price. Six of the eight actual portfolios we carry out use SPY as the underlying.
When VIX moves sharply higher, as it did during Thanksgiving week, the long side of our calendar spreads (the options with more remaining life and therefore the ones with a higher absolute value) increase in value by more than the short-term options that we are short.
If an option trading at $6.00 goes up 10%, the option will be worth $.60 more, while a short option covered by that longer-term $6.00 option might be trading at $.90, and it might only go up by $.09. If you had 10 of those spreads in place, your portfolio would increase in value by $510 just because of the higher option prices that result when VIX moves higher.
Big changes in VIX obviously cause big changes in portfolio values. In the past few weeks, the big changes in VIX came about with relatively small changes in the market, but the directional pattern persisted - VIX (as it almost always does) moved in the opposite direction of the market.
The biggest implication of this pattern for our portfolios is that we should maintain a positive net delta (i.e., be long, hoping the stock will move higher) as much of the time as possible, even if we believe the market is headed lower. (Since we really don't know what the short-term direction of the market will be, we shouldn't be guessing anyway.)
In our strategy of multiple calendar spreads, we become positive net delta by placing more spreads at strikes above the stock price than below it.
If the market moves higher, we should make some gains because of our positive delta condition (in addition to decay gains that should take place regardless of what the market does). These gains might be partially or wholly offset by losses we might incur if VIX falls with the rising market. On the other hand, if the market falls, we would lose value from the long delta condition but might make it up because VIX might rise. Maintaining a positive net delta serves as a hedge against a change in VIX.
It is important to know that VIX doesn't usually jump around as much as it has recently. Usually, it hangs out in a narrow range for months (or even years). I think that with the general level of economic uncertainty that exists today, we should not expect it to fall much below 18 for the next few months. Today's level (22) seems more appropriate to where it should be for awhile.
Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
You can see every trade made in 8 actual option portfolios (including our Weekly Mesa that gained 56% in September and 45% in October and 27% last week) conducted at Terry's Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
I look forward to having you on board, and to prospering with you.
Terry
The low-volume, holiday shortened week led to volatile conditions in the market. Geopolitical concerns remain at the forefront as debt concerns on the Iberian Peninsula have come back into focus. Spain and Portugal have joined Ireland and Greece in the ongoing debt saga that plagues the European Union.
Furthermore, in Asia, North Korea and South Korea seem to once again be entangled in conflict. North Korea fired artillery shells on Yeonpyeong Island early Tuesday which led to a sharply lower open for the U.S. markets. South Korea and the U.S. warned North Korea Friday that they are putting the Korean Peninsula on the "brink of war".
"Whenever there's unease, people take money off the table," said George Gero, vice president of Global Futures at RBC Capital Markets. "There's too much uncertainty -- the possibility of bailout discussions with Portugal and Korean saber rattling."
In the end, the Dow and S&P 500 closed the week slightly lower while the higher-beta driven Nasdaq and Russell 2000 managed lock in modest gains. That has been the story throughout the year, with the Dow and S&P gaining 6.4% and 6.7% year to date, respectively, while the Nasdaq is up 11.7% and the Russell has gained 17.2%.
On a technical basis, all of the major indices remain in a short-term neutral state. However, the seasonality that surrounds Thanksgiving shows that Monday and Tuesday are overwhelmingly bearish.
Next week brings the Black Friday retail numbers on Monday, the November employment report on Friday and the Beige Book on Wednesday. The Korean conflict will also be one to watch and of course, the ongoing European debt woes will be the focus of many as it will directly affect swings in the U.S. dollar.
Andy
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