Betting On Fear...
The Dynamic Wealth Report
April 14, 2010
by Justin Bennett, Editor
I’m always on the lookout for high profit trades. I scan the markets
looking for big potential rewards and a low degree of risk. Sometimes I
see them right away, other times the trade takes a while to develop.
I’ve been stalking one potential trade for a while now. I’ve held off,
but now the trade’s starting to look really interesting. The entry risk
is relatively low… and the profit potential is huge.
The trade idea I’ve been watching is in the Volatility Index (VIX).
So just what is the VIX?
The VIX is an index on the Chicago Board Options Exchange (CBOE). In a
nutshell, it’s a measure of volatility in the marketplace (the lower the
volatility, the lower the reading of the VIX). When markets are trending
higher, as they are now, volatility tends to decrease.
You may be familiar with the old market saying, “Markets climb the
stairs, only to jump out the window.” This saying holds true because
investors become complacent as the market trudges higher.
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Then something happens… bad news, bad earnings, or maybe just a change
in sentiment.
The market gets spooked… and all that complacency turns into selling
panic. Investors rush for the exits and the market “jumps out the
window”. When a selling panic sets in, the VIX reading explodes higher.
A rising VIX reflects increasing amounts of fear in the marketplace.
That’s why the VIX is commonly referred to as the “fear index”. When
panic hits the market, the VIX explodes higher.
Right now the VIX is pricing in high levels of complacency…
The majority of investors are very bullish right now. All seems well
with the markets. The worst seems to be behind us and the VIX confirms
this with a low reading… just under 16.
And this is where the trade set up comes in...
In my opinion, the current VIX reading is way too low, relative to the
outlying risks in global markets. The last time the VIX was this low was
in May of 2008, before the markets went on a death defying roller
coaster ride.
Let’s take a look…
Premiums for call options in the VIX are now
relatively inexpensive. The
VIX is showing a reading of just below 16. I believe now is a good time
to nibble on some VIX call options.
It’s a relatively simple trade if you know how options work.
For the sake
of time and space, I’m going to assume you understand the basics of
option trading.
I’m looking at the call options for June 2010. For example, currently
the June 17 Call can be purchased for around $4.60.
What are the risks of this trade?
The markets could trend higher straight through the June expiration
without a hiccup. The VIX would trend lower and
you would lose the
premium you paid for the call option.
What’s the potential reward?
A number of fundamental stories could trigger a short term selling
panic. Given the right story, the VIX could spike up to around 30 very
quickly.
There are some big landmines in the marketplace right now.
We have sovereign debt problems in Greece, Italy, Spain, and Portugal.
Interest rates are starting to rise and the fragile U.S. housing market
is still grasping at recovery. Or, maybe a poor U.S. earnings season
could send overvalued stocks lower.
All we’re betting is the marketplace becomes
less complacent between
now and mid-June. If truly bad news does appear, the markets may panic
and sell off rather quickly. In this case, the VIX will spike and
our
call options should rise in value.
Keep in mind, this is strictly a speculative trade…
Be sure you mind your position sizing rules and don’t load the boat on
this (or any) trade.
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