The Secret To Trading The VIX
The Dynamic Wealth Report
June 9, 2010
by Jay Chernoff, Editor
Everyone thinks professional traders have these great secrets to trading
– silver bullets guaranteeing profits. It turns out there’s really
nothing secret about being a good trader. Discipline, timing, research –
these are things anyone can do with time and effort.
But there’s at least one exception to the rule, the VIX. Professional
traders don’t want you to know the secrets to trading this popular
index. They want to keep those profits to themselves.
But you too can share in the wealth.
Let me tell you how…
But first, a little background.
The VIX is an index of stock volatility created by the Chicago Board of
Options Exchange. For those of you interested, the index is based on S&P
500 index options prices. It measures the market’s expectation of 30-day
volatility.
All it really means is the VIX measures how volatile or unstable stock
prices are.
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When share prices drop a lot in a short period of time, the index goes
up. It’s why it’s often called the “fear gauge”. It’s also why CNBC
talks about it so much. We all know the media loves fear.
On the other hand, when stock prices move up or sideways, the volatility
index tends to drop. Investors usually aren’t worried when stocks go up
or stay flat.
As I was saying earlier, professionals want to scare you away from
trading the VIX. They’ll tell you it jumps around way too much. It’s way
too risky for non-professionals.
But that’s the point - you can rake in big profits because it moves so
much!
Under normal market conditions, the VIX moves within a certain range. This range is from roughly 15 to about 30.
When it gets to 15, the market is calm and most likely equity prices
have been climbing. If it hits 30, things are looking pretty hairy. Not
surprisingly, the historical average for the “fear gauge” is right in
the middle of the range at 22.
But here’s something interesting, the index rarely spends much time at
either end of the range.
Not only that… when conditions get scary, it really starts to move.
On April 20th, the index was sitting at 15.73. Then out of the blue,
investors woke up and remembered Greece and Spain could default on their
debt obligations. Meanwhile, oil was pouring into the Gulf of Mexico at
an unprecedented rate. Boom!
By May 7th, the VIX was over 40!
I distinctly remember October 27th, 2008. It’s when Lehman Brothers
collapsed and the credits market crashed. That day it got as high as 80
– the highest in the history of the index.
To review, the VIX trades in a range under normal conditions. However,
it doesn’t like to hang out at either end of the range. In addition, it
can quickly skyrocket if fear takes over in the market.
There’s a perfect trade for this scenario.
It’s called a strangle.
The strangle is a simple options trade which happens to be commonly used
by even the most sophisticated traders.
A strangle trade uses two options. It’s when the investor buys one call
higher than the current price and one put lower. You make money on the
trade when the price moves higher than your call or drops lower than
your put.
As I write this, the VIX is currently trading around 35. Let’s say you
want to buy a strangle on it. We already know it’s at the upper end of
the usual range. It won’t likely remain at this price for long. We also
know in volatile markets (like we have now) it could go much higher.
A good trade at this price is the July 32.5 – 37.5 strangle. Remember,
it means you are buying the 32.5 put and the 37.5 call for the month of
July.
You’d buy the higher calls and lower puts because these
“out-of-the-money” options are much cheaper. So, you can profit from a
move in either direction without spending a bunch of money.
You’ll have just a few weeks to make money on this trade before the
options expire. A ton of time when dealing with the volatile VIX.
The best part about this trade - it doesn’t matter which direction it
moves.
You can sit back and watch the inevitable rise or fall of the “fear
gauge” and start to count your profits.
• Gold (Over $1,245 an ounce)
Yesterday, gold closed at an all time record high. Three days into a
winning streak, it’s clear investors are flocking to the safety of gold.
EuroZone worries are the big catalyst for the climb.
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