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Even though the VIX is already at a five-year low, VIX futures seem to be predicting that it could go even lower, and trader Andy Waldock of Commodity & Derivative Advisors offers an idea for playing its inevitable rebound.

The S&P 500 is within spitting distance of the 2007 highs. Remember 2007 when the economy was rolling along and everyone used the equity from their first house to buy a second or, third? Home ownership became everyone’s entitlement—the American way. Five years of deleveraging later and we’ve figured out that corporations know how to manage their businesses better than the bureaucrats know how to run our economy. Corporate balance sheets are healthy and interest rates are at all-time lows. Unfortunately, the government can’t figure out spending for a quarter, let alone an entire fiscal year.

We have written extensively on the topic of using stock index futures to hedge your retirement account. Typically, the response is, “How can I sell something I don’t own?” This week we are going to discuss volatility index futures. This is a product offered by the Chicago Board Options Exchange and it trades opposite the stock market. Therefore, buying VIX futures provides protection from a downdraft in the stock market while simultaneously limiting the risk of the hedge position.

First, it’s important to understand that volatility in the stock market is primarily associated with fear. Stock market declines put fear into the market’s participants. Fear generates wild swings in the market. Therefore, volatility increases with fear. The stock market collapse of 2008 was even wilder than the post tech bubble crash of 2000. The winter of 2008 saw the average monthly range in the S&P 500 increase to more than 145 points per month. This meant that the stock market had an average range between the month’s high and low of more than 20%. This continued for eight consecutive months.

VIX futures trade monthly and they are a direct measure of the volatility expected within the next 30 days. Therefore, if the price of the VIX futures is 17.00, the market expects that the S&P 500 futures may move as much as 17% over the next 30 days. The all-time high for the VIX futures is 80.86, set in November of 2008.

This leads us to the second point. Fear is an emotion. Emotional actions exceed rational behavior in the markets. The all-time high in the VIX futures suggested that the market could be priced more than 40% higher or lower from the prices we were trading at the time within 30 days. The S&P 500 closed at 812 in November of ’08. The VIX price suggested that by Christmas, we could’ve been trading as high as 1136 or as low as 487. The reality was that we traded from a low of 730 to a high of 836 in December of 2008. Clearly, the imagination of the market’s participants got the best of them.

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