Option Tip of the Week
What to Do About the VIX Crash:
As most of you know, VIX is the volatility measure based on option prices of the S&P 500 tracking stock, SPY. It has fallen all the way to 15.23, the lowest level we have seen in over four 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.
But 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, repercussions from the Japanese disaster, and/or unrest all over the world.
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 about 20. I think it is inevitable that VIX will climb back up toward, or above, 20 in the near future.
A Time to Buy VXX?
This stock is highly correlated to VIX. It closed yesterday at $27.55, the lowest price it has ever recorded in its 2 1/4 years of existence. For a couple of months in the last year, VXX traded in the $100 - $130 range to give an indication of just how high it might go. Just a month ago, it popped up to $38 when the Mid-East crisis started (you may remember that I sold it short at that price, and bought it back in two weeks when it had fallen to about $30). Now I personally plan to buy VXX at the current level.
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.
Another way to play VXX is to buy the stock and write a call against it, or at least against some of it. The May-11 30 call can be sold for $1.20 which would give you at least a 4% gain for one month if the stock closes below $30, or better than a 13% gain if it closes above $30, 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.
If the month goes by and the call you sold expires worthless, presumably you could sell a June option for a similar amount, and set yourself up to enjoy a 4% gain every month that the stock does not get higher than $30. As a general rule, I do not like writing calls against stock I own, but this case is a little different because I believe the stock is unlikely to move much lower.
I plan to sell only half as many calls as I buy VXX, keeping some uncovered stock just in case it skyrockets to the $120+ level that it enjoyed as recently as April, May, June, and July a year ago.
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).
In any event, I think it is a good buy right now, being at its lowest level in its entire existence.
Happy trading.