The Secret To Trading The VIX

| June 9, 2010 | 0 Comments

Everyone thinks professional traders have these great secrets to trading – silver bullets guaranteeing profits.  It turns out there’s really nothing secret about being a good trader.  Discipline, timing, research – these are things anyone can do with time and effort.

But there’s at least one exception to the rule, the VIX.  Professional traders don’t want you to know the secrets to trading this popular index.  They want to keep those profits to themselves.

But you too can share in the wealth.

Let me tell you how…

But first, a little background.

The VIX is an index of stock volatility created by the Chicago Board of Options Exchange.  For those of you interested, the index is based on S&P 500 index options prices.  It measures the market’s expectation of 30-day volatility.

All it really means is the VIX measures how volatile or unstable stock prices are.

When share prices drop a lot in a short period of time, the index goes up.  It’s why it’s often called the “fear gauge”.  It’s also why CNBC talks about it so much.  We all know the media loves fear.

On the other hand, when stock prices move up or sideways, the volatility index tends to drop.  Investors usually aren’t worried when stocks go up or stay flat.

As I was saying earlier, professionals want to scare you away from trading the VIX.  They’ll tell you it jumps around way too much.  It’s way too risky for non-professionals.

But that’s the point – you can rake in big profits because it moves so much!

Under normal market conditions, the VIX moves within a certain range.  This range is from roughly 15 to about 30.

When it gets to 15, the market is calm and most likely equity prices have been climbing.  If it hits 30, things are looking pretty hairy.  Not surprisingly, the historical average for the “fear gauge” is right in the middle of the range at 22.

But here’s something interesting, the index rarely spends much time at either end of the range.

Not only that… when conditions get scary, it really starts to move.

On April 20th, the index was sitting at 15.73.  Then out of the blue, investors woke up and remembered Greece and Spain could default on their debt obligations.  Meanwhile, oil was pouring into the Gulf of Mexico at an unprecedented rate.  Boom!

By May 7th, the VIX was over 40!

I distinctly remember October 27th, 2008.  It’s when Lehman Brothers collapsed and the credits market crashed.  That day it got as high as 80 – the highest in the history of the index.

To review, the VIX trades in a range under normal conditions.  However, it doesn’t like to hang out at either end of the range.  In addition, it can quickly skyrocket if fear takes over in the market.

There’s a perfect trade for this scenario.

It’s called a strangle.

The strangle is a simple options trade which happens to be commonly used by even the most sophisticated traders.

A strangle trade uses two options.  It’s when the investor buys one call higher than the current price and one put lower.  You make money on the trade when the price moves higher than your call or drops lower than your put.

As I write this, the VIX is currently trading around 35.  Let’s say you want to buy a strangle on it.  We already know it’s at the upper end of the usual range.  It won’t likely remain at this price for long.  We also know in volatile markets (like we have now) it could go much higher.

A good trade at this price is the July 32.5 – 37.5 strangle.  Remember, it means you are buying the 32.5 put and the 37.5 call for the month of July.

You’d buy the higher calls and lower puts because these “out-of-the-money” options are much cheaper.  So, you can profit from a move in either direction without spending a bunch of money.

You’ll have just a few weeks to make money on this trade before the options expire.  A ton of time when dealing with the volatile VIX.

The best part about this trade – it doesn’t matter which direction it moves.

You can sit back and watch the inevitable rise or fall of the “fear gauge” and start to count your profits.

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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