Index & Currency Plays to Profit from the Market Volatility

It looks like yesterday's market gobbled up the gains of the Thanksgiving rally. It was to be expected since the Monday following Black Friday is historically a down day. (See my previous article, “The Turkey Effect,” for further details.) Last week's rally sparked hope of a market bottom; I, however, do not share that hope as evidenced by the following charts of the the VIX and the S&P 500.

What the charts are saying and how we can profit from them

The volatility index, the VIX

The chart of the VIX, the market volatility index, shows that it's been trading in a horizontal range for the past two months. The lower support level is around 55 (you could argue the case for support around 47 as well). Upper resistance is defined by the 80 level. A bottoming tail formed on Friday and today's gap up further emphasized this turn-around in direction. (Remember that the VIX and the markets move counter to each other.) So, is there any way one can profit from this channeling behavior?

Well, you can't actually buy the VIX but there are options on it with good liquidity at many strike prices. One conservative options play is to sell bull-put credit spreads on a day like today when the VIX is bouncing off lower resistance. Try the December 55/50 put spread (sell the 55 strike and buy the 50 strike) or the December 50/45 spread if you're of a more conservative bent.

This is a directional play and as such you don't want to wait for the price to move against you so I'd recommend closing out the spread when the VIX gets near upper resistance at 80. When it shows signs of heading back down, I'd reverse the process by selling an at-the-money (ATM) or slightly out-of-the-money (OTM) bear-call credit spread.

Nothing channels forever, so you may only get to do this a couple of times, but it could be worth your while. If the trade does happen to move against you, close it out or roll down the strike prices. I'd recommend setting your stop-loss at the break-even (B/E) price. For a bull-put credit spread, the B/E is the lower strike price less the net credit; on the bear-call side, the B/E is the price of the higher strike plus the net credit.

The major market indexes

The chart below shows the daily price action of the S&P 500. (I chose the S&P because it's the benchmark index for most comparison purposes but all of the other major indexes look similar.) You can see that it's found a new trading range bounded by a downwards sloping channel. For reference, I also included the 30 day exponential moving average as it seems to coincide with the upper price channel boundary.

We can play this in several ways using equities and options. (This channel is also a handy reference for index futures traders, too.) First, there's the tracking stocks—the SPY, DIA, QQQQ, etc. along with their double and triple long/short ETF counterparts. You can buy these when the index turns up from its lower channel boundary, sell when it reaches the upper boundary, and then take a short position (by either shorting the tracking stock or buying the short equivalent) when the index begins to head back down.

Options players can play the options on either the indexes or the tracking stocks. Options on the latter are cheaper and generally more liquid than the former. Possible options strategies include the above-mentioned credit-spreads, debit-spreads, or straight calls and puts. Because of the time decay factor inherent in options pricing, I prefer buying options with strikes that are at least 6 months out if I plan on holding them for more than a day or two.

A note on currencies

The Greenback

The long US dollar tracking stock, the UUP, has been trading in the $26-$27 range for the past six weeks. A definitive break on either side will likely continue in the same direction—just a heads up to you currency traders out there. (There are no options on the UUP, alas.)

The Yen

The Japanese yen is the only currency (with a tracking stock) that is bucking the buck. Its tracking stock, the FXY, has been rising steadily since its October 6th breakout and is less than $2 away from hitting its yearly high at $108.79. This tracking stock is optionable and selling the December 105 cash-secured put when it next takes a breather (maybe as soon as Tuesday) would be a nice way to ease into a long position. Note that many of its options are thinly traded and you can't buy any further into the future than June 2009.

Disclosure: The author has no positions in any of the above mentioned stocks or options.

Comments

[Smarty_Pants:]

One other possibility for trading the stock indices. Delta neutral positions using leveraged ETFs and options on same. Establish delta neutral positions when the market is near one extreme and rebalance near the opposite extreme. Repeat ad nauseum.

I have never tried this myself, though it looks like a savvy way to establish a low risk position with the possibility of good returns for a market which moves a lot.

2008 Dec 02 11:28 AM

[je:]

FXC might be a better way to play the dollars down side. With the naturalresources poised to move up andthe dollar to go down the Canadian dollar has been really over sold. Ithas a double bottom formation and currently it is testing the window that was opened on Nov. 20th forsupport.


The break to the down side occured at $97.50 and that is also the target of the double bottom. The June $80 call is $5.20 although I expect the move rather quickly the extra time is insurance especially with gold trying to get out of the starting gate.

2008 Dec 03 08:40 AM