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Make Up to 114% if the Market Crashes in the Next Month

Michael J. Carr and Amber Hestla-Barnhart

Trading market volatility is possible, although it requires a different type of analysis than trading stocks. When selecting stocks to buy, we generally look for value defined in terms of earnings, dividends, cash flow or other information found in financial statements.

There are no similar tools for assessing the fair value of volatility, which is at least partly based on emotion and money flow, two factors that cannot be predicted. Volatility tends to increase when prices fall, a sign that traders and investors are reacting to the sell-off in emotional terms by reducing their exposure to stocks.
Money flow is also a factor that affects market action. For example, the recent drop in gold prices may have been driven by large sell orders coming from Cyprus as an attempt to raise cash to address their financial crisis. If that's the case, it would be an example of selling driven by one investor's need to have money "flow" out of the market. Selling tends to create outflows from markets as some investors raise funds to meet margin calls and a variety of other factors.

Because we cannot predict emotions or money flow needs, we cannot know the right value of volatility.

Even without knowing what the precise level of volatility should be, we can see some patterns in the data. Below is a monthly chart comparing volatility, shown as the CBOE Volatility Index (VIX), to SPDR S&P 500 (SPY). Visually, VIX spikes more often and trends are less pronounced. That means VIX does not make a good buy-and-hold investment.

We can trade VIX using options or exchange-traded notes (ETNs). An ETN is similar to an exchange-traded fund (ETF), except it holds derivatives like futures contracts instead of cash. VIX ETNs have generally underperformed the index. This is seen in the next chart, which uses weekly data and shows that iPath S&P 500 VIX Short Term Futures ETN (VXX) has moved lower with VIX since it started trading in early 2009.

From a trading perspective, the most important thing to notice in the chart is how VXX failed to spike higher when VIX did. This means VXX did not deliver profits when VIX spiked, as traders would expect.

There are other VIX ETNs, but the problems are similar in that they generally fail to deliver on the days when VIX spikes. Traders looking to trade volatility should consider trading options on VIX.

It is important to remember that the precise level of volatility at any time is unpredictable. That is another factor that makes VIX ETNs difficult to trade. However, options allow us to trade this idea.

Using all available data for VIX, the long-term average value is about 20. It is now at about 17.56, or about 12% below average. It is reasonable to expect VIX to move back toward the long-term average.

In the past week, we have seen VIX make moves that are about five times larger than the move in SPY. On average in April, VIX has moved 2.5 times as much as SPY on a daily basis. Using the average value of the relationship, we would expect to see a decline of about 4.8% in SPY to push VIX to average.

These numbers explain why VIX is a leveraged trade on SPY -- a large move in SPY leads to a larger move in VIX.

Options have expiration dates and expire worthless if the expected move does not occur in a certain time frame. Options on VIX are relatively expensive now, reflecting the high risk traders seem to believe is in the current market.

A VIX call option with a strike price of $17 expiring in May is trading for about $1.40 and would be worth at least $3 if the VIX rises to an average level before expiration. That offers a potential gain of 114% if the market crashes in the next month.

The VIX June 17 Calls can be bought for about $2.15 and offers a potential gain of 40% if stocks fall by 5% or more in the next two months. Because there is more time before expiration, the calls should actually trade at a premium if there is a steep market correction in the next several weeks.

Putting 1% of your account into the June call options could be considered the cost of insurance in the event of a market crash. The gain from the VIX calls would offset the losses seen in the rest of your portfolio.

Recommended Trade Setup:

-- Buy VIX May 17 Calls at $2 or less
-- Do not use a stop-loss, this is insurance against a market crash
-- Set initial price target at $3 for a potential 50% gain in one month

-- Buy VIX June 17 Calls at $3 or less
-- Do not use a stop-loss, this is insurance against a market crash
-- Set initial price target at $4 for a potential 33% gain in two months

Both calls work together to reduce risk. May calls offer a higher potential return and June calls offer protection for a longer period of time.

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