VIX, the so-called “fear index” hit a 5-year low last week. What does that mean for investors, and how can they capitalize on this new development?
How To Bet On Volatility Rising
The most popular measure of options prices is the average implied volatility of puts and calls of the S&P 500 tracking stock (SPY). (Only monthly options are included in this measure, and the increasingly-popular Weekly options are excluded, a serious mistake in my opinion.)
The mean average of VIX is 20.54. When VIX is below 15, options prices are considered to be extremely low and when VIX is above 35, option prices are considered to be unusually high. In the crash of 2008, VIX rose to 80 briefly and then fell all the way back to the mean average in about a year. More recently, about a year ago, VIX rose to 40 when the possibility of a European economic meltdown was making headlines.
When fear is high, option prices as measured by VIX are high, and vice versa. Last week, VIX fell to 13.30, a low number not seen for five years. Investors seem to have little fear. By historical standards, they are complacent. After all, the market has moved higher for six consecutive weeks.
But the market is driven by sentiment. And sentiment changes. One interesting thing about VIX is that it ultimately moves toward its mean average. Reversion to the mean is just about the most powerful thing that we know about VIX.
At this point in time, a single news story that Greece or Spain or Italy might encounter difficulties refinancing their debt, or China is slowing down, or Israel bombs Iranian nuclear plants, and VIX will soar through the roof.
So how do you make money when VIX rises (as it inevitably will)? You could buy calls on VIX, but they are expensive (since everyone knows that VIX is bound to rise sometime), and you lose money if VIX stays flat (or only moves slightly higher, not enough to cover the cost of your call).
One serious problem with options on VIX is that you cannot place spreads (such as calendars or diagonals) with long and short options in different months without posting extremely high cash margin requirements (and you can’t do it at all in an IRA).
There is a better alternative out there, and it is a proxy for VIX. It is an ETN (Exchange Traded Note) called VXX. It is based on the futures of VIX and is highly correlated to VIX. Last Friday, VIX closed at 13.45 and VXX closed at $11.20. Last fall, both numbers were about at the 40 level, and in 2008, they both got as high as 80.
Of course, you might just buy VXX and hope that VIX rises, but there is a problem with owning VXX for the long run, and that is a thing called contango. We can’t discuss contango at this time, but essentially, it pushes down the price of VXX about 8% a month at today’s futures prices, all other things being equal (i.e., VIX and VIX futures remain flat).
Our preference for betting that VIX (and VXX) will rise when VIX is at unprecedented low levels is to buy calls on VXX (right now, one of our 8 portfolios owns VXX calls expiring on September 21, 2012). We sell at-the-money Weekly calls against these long positions, but we only sell enough calls to cover the premium decay on our long call positions. We have 50% more long calls than we have short calls.
If VIX stays flat, our portfolio should break even (compare this to buying calls on VXX which would lose 100% of their value if VIX remains flat, or falls). If VIX moves slightly lower (unlikely, in our opinion), we should lose a little. If VIX moves slightly higher, we should make a small gain. If VIX moves significantly higher, we should make a windfall gain, maybe five or ten times our total investment.
We believe that our portfolio (we call it the Honey Badger portfolio) provides exceptional protection against a 1987-like market meltdown. Last week, one writer, Todd Feldman, saw similarities between today’s market and the market in 1987, just before the crash – see it here if you are interested.
If the market crashes for any reason whatsoever, or if VIX moves significantly higher for any reason (or for no reason other than reverting to its mean), our Honey Badger portfolio should yield huge returns.
You can mirror our Honey Badger portfolio, or any of our other seven portfolios, and not have to make a single trade on your own, through the Auto-Trade service offered by TD Ameritrade/thinkorswim.
To celebrate the re-establishment of Auto-Trade at TD Ameritrade/thinkorswim, we are offering our Premium service at the lowest price in the history of our company. We have never before offered such a large discount. If you ever considered becoming a Terry’s Tips Insider, this would be the absolute best time to do it.
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With this one-time offer, you will receive all of these Premium Service benefits for only $75.95, (normal price $119.95). I have never made an offer anything like this in the eleven years I have published Terry’s Tips. But you must order by midnight on September 4, 2012. Click here, and enter Special Code Auto12 in the box on the right side of the screen.
I feel confident that this offer could be the best investment you ever make in yourself. Celebrate the resumption of Auto-Trade at TD Ameritrade/thinkorswim with us. But do it before the day after Labor Day, as this offer will not be available after that day.
I look forward to prospering with you.
P.S. If you would have any questions about this offer or Terry’s Tips, please call Seth Allen, our Senior Vice President at 800-803-4595. Or make this investment in yourself at the lowest price ever offered in our 11 years of publication – only $75.95 for our entire package using Special Code Auto12.