Lessons from Last Year: Protect with VIX Call Options

by: Option Maestro

As we approach the one year anniversary of Lehman Brother's bankruptcy and the Merrill Lynch-Bank of America (NYSE:BAC) merger, I decided to write a quick post to share what I learned from it all.

The Night: I remember like it was only yesterday. I was trying to study for an Environmental Economics exam, but I was distracted by the nightly news. I was caught up in watching people pour in and out of the Lehman building with boxes of their belongings, thinking what will this mean for the future of the stock market? Lucky for me, I was a shareholder in the bank that was saved that night, as Merrill Lynch was acquired by Bank of America (BAC).

The Only Green Call Option: The following morning, I remember watching many of my long call option positions losing huge percentages. However I had one call position that gained quite a few percentage points... the Volatility Index [VIX]. I had purchased October 30 strike call options for very little premiums in August. This single position (less than 1% of my portfolio at time of purchase) hedged my portfolio quite a bit during the market massacre to come in the following months.

The Yahoo Finance chart below shows the S&P 500 (blue line) and the Volatility Index (red line) from August 20, 2008 until September 11, 2009.

click to enlarge

Click to enlarge

With increased levels of uncertainty coming into the market, the VIX spiked. This spike mixed with a huge increase in implied volatility on VIX option contracts caused call premiums to sky rocket. It is estimated that a $1,000 investment for a VIX call trading at $5 a contract just weeks before the VIX crossed 25, would have returned over $1 million dollars at one point by October VIX expiration.

The Trade: Prior to last year's market sell off, the CBOE Market Volatility Index at those levels was unheard of, so far out of the money call options barely fetched a premium, however things are much different this year causing out of the money calls on the VIX to go for higher premiums.

However, levels of volatility hit a fresh 52 week low on Friday September 11, 2009, and I believe it is a good time to protect with VIX call options. I have been accumulating VIX call contracts for the October 30 strike for a couple weeks now; I have paid as much as $280 per contract and as little as $150 per contract.

I am not anticipating a market sell off like the one experienced last year anytime soon, however protection is at the cheapest level in a year, so now may be a good time to buy some VIX call options to protect. To learn more about trading VIX call options, risks, pricing, calculations, other strategies, and options in general, click here.

The Lesson: With huge levels of implied volatility on option contracts for the VIX, contract premiums can climb extremely fast. While I was losing money on my long positions last year, the money gained from my VIX call options helped offset it, and allowed me to reinvest the profits into beaten down stocks.

If there is one lesson I learned from last year, it was to have good portfolio protection, and I believe the best way to do this is to purchase call options on the Volatility Index [VIX].

The ideas outlined above involve the use of stock options. The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (see option volume chart).

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you will want to adjust the strike price and expiration accordingly.

Disclosure: Long VIX September 30 Call Options