volatility photoI have been toying with this strategy since the crash of Lehman Brothers. Some may call it speculative, but I consider it to be a very contrarian strategy and on the downside a fundamental play, and on the upside a possible hedge (I will explain shortly). However, read the full post before thinking I have become some speculator investing in penny stocks portrayed in Google ads that have “guaranteed returns of 10x in a month”.

Let me start by how long stocks can stay elevated. Here is Cisco’s PE average ratio 1996-2003.

1996 1997 1998 1999 2000 2001 2002 2003
46.45x 44.32x 75.26x 122.13x 173.18x 60.67x 60.22x 38.05x

For seven years Cisco’s PE was above 38, it went up to 232 PE in 2000 at its height! This is just one example of the many cases, where a specific stock stays at extremely elevated valuation for years.

Now about the VIX:

The VIX is a fairly recent volatility index which was introduced by the Chicago Board of Options Exchange in 1993. VIX is better known as the ‘investor fear gauge’ as it illustrates the bullish or bearish disposition of market participants. Depending on the participants, the volatility of the market varies from high to low. S&P 500 index is useful to keep track of the market ups and downs, however, for investors, observing this common index is not enough. Especially for individuals who indulge in short selling, an index which presents the expected market behavior is highly essential. That is where VIX comes in.

VIX provides investors with an indication of expected volatility levels in the U.S. market during the coming 30 days. It is a forward index which takes into account the S&P 500 index options and estimates volatility taking out the average weighted prices of S&P 500 index puts and calls over a wide range of strike prices. In simple words, VIX depicts the implied volatility of the S&P 500 index options. By implied volatility it means the expected increase when the market is bearish and the expected decrease when the market is bullish. Basically, keeping into perspective the common belief, when the market is bearish, there will be more volatility as such market condition is viewed as being risky. On the other hand, during the bullish market, the volatility will be low owing to the less risky market condition. Therefore, when the market is bearish, the percentage figure of VIX will be high and when the market is bullish, the percentage figure of VIX will be low. As the index presents the ‘expected’ market volatility, the percentage of VIX depicts the sentiment of market participants.

Market moves very quickly depending on the changing sentiments of market participants. Any expert investor would stress on the importance of market participants’ sentiments or their collective outlook. Especially in case of shorting, VIX provides a better more forward-looking insight into the market price fluctuations. Since 1993 when VIX was introduced the average VIX percentage remained well below 35. However, during the period of 1998 till 2003, which was the time when the Russian debt crisis and the following dotcom bubble burst hit the financial market investors witnessed VIX fluctuating from a low percentage of 20 to a high percentage of above 40. More interestingly, after the collapse of the Lehman Brothers, the index shot up to a high 80 at the end of 2008 illustrating the bearish panicked sentiments of the market participants. However, even after the worst recession since the great depression the VIX went down to ~23 within a few months. The average price of the VIX since inception is ~20.

click TWICE to enlarge

What is particularly interesting to note here is the trend of VIX during the mentioned periods. If one observes the chart of VIX during the period of 1998 till 2003, or during the 2008 financial crisis, it is evident how the index fluctuates in matter of few months, days, and even hours. The index reaches its peak and it doesn’t take long for it to go down. The trend is also predictable as once the index shoots up, it is very likely for it to come down in the short-run mostly as the index is based on market participants’ sentiments or expectations. These inconsistent up and down movements of the index also represent the intensity or the significance of the implied market volatility. My rationale behind this is as follows; when the market fears a bad recession or the end of the world the VIX spikes however volatility cannot stay elevated for too long. The 9/11 attacks were another good example of a temporary spike.

Either the world truly does end and the only thing with value is physical precious metals and weapons, or volatility goes down as the world realizes the armageddon has not arrived yet. This is why the VIX shot up so high when Lehman collapsed, and eventually calmed down when the crisis started to ebb.

The way up is more hard to predict, as the VIX stayed at very low levels from the end of 2004 to mid of 2007 with no spikes above 20 until July 2007. However it is a good tool for hedging against market declines.

ETFs are ways through with a person can invest in the VIX. VXX and VXZ are short to mid-term volatility ETNs/ETFs, which are awful and do not track the VIX properly. An example from experience. I bought one of the VIX ETNs when the VIX dropped below 15 before the Japanese quack. Within less than a month the VIX went up 25%, and I lost 11%.

However the options are interesting to use for the VIX.

With the VIX currently trading at over 42, the puts look like a good way to profit of this herd behavior.  The one flaw with the options, are that the options all expire within a few months. Even though most of the time the VIX reverts to the mean shortly, after Lehman it took close to eight months to get to ~23.

The longest dated options I discovered are VIX puts expire on February 23, 2011. I am chosing options with a strike price of 23, to provide a “margin of safety” above the “intrinsic value” of 20. The spread is very wide (as it is for most options), but it can currently be purchased for $1.60.

I hate to use Black-Scholes and I wanted to get this piece up while the market is closed (since the VIX is highly volatile), but I will post a P&L  when I get a chance. Needless to say a drop from 42 to 23 should be highly profitable.

Disclosure: I own VIX put options which will rise in value if volatility decreases

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit

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