Bullish vs. Bearish VIX Trades

01/10/2013 8:00 am EST

Focus: OPTIONS

As the markets sighed in relief last week over one fiscal cliff averted, with several more to go, the VIX registered its largest one-week drop ever of 39%. Option trader Greg Loehr of OptionsBuzz.com offers some ideas if the VIX rebounds or heads even lower.

The new year is being brought in with some of the lowest VIX levels in the past two years. Back on August 17, the VIX bottomed out at 13.3. Last Friday the low was 13.64. Granted, Friday readings are understated since option prices are lowered throughout the day to take into account the weekend’s time decay. Even so, the VIX closed Monday at 13.79.

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This is about as low as the VIX is going to go. In last week’s Live Trading Session, we looked at what the options were saying about this.

So does this mean that it’s time to buy volatility? Not necessarily since the volatility can remain low for a very long time. Even though it doesn’t take much movement to overcome the daily theta, stagnant markets will bleed you slowly to death unless something happens. Without a pop in the volatility or a bigger-than-expected movement, simply buying options when the volatility is low isn’t necessarily a smart way to go.

This is where you can get into trouble with some of the old adages. For instance, the “buy low, sell high” rule needs further explanation. If you buy a stock low, and the stock doesn’t go higher, you’ve only lost the opportunity to have invested your money in another stock that could have gone up.

If however you buy options when they’re low, you can’t simply wait around for the options to go up in value because you’ll be fighting time decay—even if it’s only a little each day. So the rule needs to be amended to say something like: “Buy when it’s low, AND only when you think it’s going to go up.”

As an aside, the “sell” part of the old adage should say something like: “Sell when it’s high, AND you think it’s going lower.” Don’t just sell because it’s high because it can always go higher. Right, 2008 volatility sellers?

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If you want to buy volatility, then maybe it’s prudent to wait and let the market tell you that the volatility is really starting to move higher. With the VIX you can just look at the VIX. Is it actually starting to tick higher? Is there something in the broader market telling you it might be going higher—such as a bearish technical/fundamental reason?

How about this as a reason to buy volatility: the volatility of the volatility. The VIX basically says how much the market is expected to move going forward. Another way of saying this is that the VIX is trying to predict future historical volatility for the S&P500.

The options are also trying to predict the future historical volatility of the underlying. So when you look at the implied volatility of the VIX options, you’re looking at the volatility of the volatility. That’s what the bottom part of the above graph represents. When the implied vol of VIX options bottom out, things can start to happen. Even if it’s only a pop of a couple VIX points, you’ll notice that extremely low implied vol readings coincide with higher VIX readings over the next few days to a month out.

The implied volatility hit a low on Friday January 4. Of course, that low reading would also be taking into account the time decay of the upcoming weekend, but it still remains at multi-year lows.

To me, this would be a reason to start looking at bullish VIX strategies. Why bullish? Because despite the fact that implied volatility tries to predict the future range of a stock, with the VIX the future range is really bound by a low reading around 13′ish. The VIX isn’t going to zero. So that leaves “up” as the range.

But I’m not saying to go out and buy VIX calls right now, but start looking. If earnings come in with positive results, well, then the VIX is probably going to stay low. And with every company in the world reducing its expectations, it won’t be hard for earnings to look good.

But if companies disappoint, then look out below. Lower market, higher volatility; and higher volatility of the volatility.

By Greg Loehr of OptionsBuzz.com

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