Recently I wrote a series of articles detailing investment strategies using the VIX, an index designed to quantify and measure the volatility of the S&P 500. The VIX index is unique in that it doesn't trend like most indexes, it "beats" like an EKG monitor. The VIX tends to have a baseline or "state of rest" level of around 12 to 14, and then a casual level of excitement might take it up to 20, more severe stress might drive it to 30, and extreme events like the 2008 crisis can send it as high as 60.
Click to enlargeRecently the VIX has mostly been responding to Vladimir Putin's efforts to bully the West, and seize the Crimean peninsula. Before the crisis the VIX was returning to it baseline after an early 2014 correction had caused it to spike to around 21. I find it interesting that a routine correction generated more fear than Putin's efforts in the Ukraine. It appears that either the markets don't fear Putin, or they think the West will appease the bully, or both.
Recent events however are a great example of the VIX strategy I outlined in a previous article. The strategy was called the "Dr Strangelove" strategy.
That in one use for the VIX Index, I call that investment strategy the Dr. Strangelove Strategy modeled off the old strategic military tactics of the cold war that inspired a movie of the same name. Like a strategic nuclear submarine placed off the coast of the former USSR that just patiently sits there until an external unforeseen event happens that triggers a pre-planned automatic defensive response. The 10% VIX Index holding just sits in the portfolio and goes nowhere for extended periods of time, creating a drag on the portfolio return worse than cash, but then "Ka-Pow," 2008 hits and the VIX Index hedge automatically springs into action like a reflex protecting the portfolio from losing the hard earned gains of the last decade.
Looking back, December 2013 would have been the ideal time to execute operation Dr Strangelove. At the turn of the year things often change, and lead to increased volatility. Investors could have purchased call options on the VIX as insurance against turn of the year calendar risk in December and rode the VIX up to the typical exhaustion level of 20, sold the options and bought puts for the ride back down to the 12-14 range, bought calls again, and rode the bully Putin scare up to around 18, and then sold the calls on the news of the Crimean vote when the VIX turned downward.
Yea, I know, investing while looking in a rear view mirror is easy. Everyone is an investment expert when using historical data. That is why I am writing this article, to demonstrate how using the VIX can be used looking forward.
Right now the VIX is slowly working its way back to the 12-14 level, but, at least in my opinion, there are some really dark clouds hanging over the market. I wouldn't expect the VIX to reach the 12 level in the near-term, and maybe not even the 14 level. Looking forward there are multiple significant "known and unknown" risks:
1) An unresolved issue in the Ukraine.
2) A potential Chinese credit crunch, and more possible Chinese bankruptcies.
3) Tax day of April 15th in a year following a very strong market. People may need to sell securities/investment, especially ones with losses like gold, to pay Uncle Sam.
4) A market near all time highs, and current Fed comments are driving interest rates higher.
5) A new Federal Reserve chairwoman and the past history of new Fed chairmen being tested shortly after taking office as happened in 1987 and 2008.
6) There are always "unknown unknown" risks, and those are the most dangerous of them all. However, by definition you can never know when those will happen, that is what makes them unknown unknowns. Those are the types of risks that can trigger "black swan" events, they blindside the markets. While you can't predict a black swan event in advance, you can however identify events and developments that have in the past led to black swans. Credible threats of possible war can be one of those situations that sets the stage for a future financial panic. Be careful however, the start of the Persian Gulf war triggered a sharp market rally, so there are never any certainties when handicapping the future. What seemed to be an unknown unknown really wasn't an unknown unknown and was already fully discounted in the market.
FINANCIAL MARKETS AND THE GULF WAR : STOCKS : Dow's Point Gain 2nd-Biggest Ever
January 18, 1991
Hopes that the Persian Gulf War would be brief sent Wall Street stocks soaring Thursday.
The Dow Jones industrial average closed up 114.60, or 4.6%, at 2,623.51. It was the second-biggest daily point gain ever, topped only by a 186.84-point gain Oct. 21, 1987.
Now is the perfect time to implement the Dr Strangelove VIX investment strategy, and in fact it looks like someone with a whole lot of money already has. Today in the news it is being reported that someone has purchased $8 million worth of May 22 VIX Calls, and partly paid for them by selling May 30 VIX Calls.
The trader bought 150,000 bullish contracts on the VIX expiring in May with a strike price of 22, while selling the same number of May 30 calls in a strategy known as a call spread, according to New York-based Miller Tabak & Co. The trade cost 53 cents to put on for each contract and it will profit if the volatility gauge rises above 22.53 from the current level around 14, data compiled by Bloomberg show. It has a maximum payoff if the VIX more than doubles to 30.
I don't want to get into the details of a call spread other than to say that is reduces the cost of the trade, but limits the potential gain. The important points that I want to highlight are:
1) The person placing this trade apparently has a high degree of confidence that volatility will pick up in the relative short-term.
2) The person picked strike price levels close to the key levels of 20 and 30. He/She is long the 22 Call, which is just above the peak level associated with routine spikes similar to what we just experienced. A strike of 22 implies an expectation of volatility greater than a routine level. By my count the VIX looks to have reached that level between 7 and 11 times since 1990, depending on how you count it.
3) The VIX Futures are in contango and the May VIX trades at $16.25, and April VIX trades at $15.70. If nothing happens between now and expiration in May the $8 million will be lost.
4) By picking the 22 verses the 20 Call the person was able to lower the cost of the trade, but it also requires more than the routine level of volatility to develop.
The following is a current pricing list of the VIX May Call Options. I'll use this article and quote sheet for a follow-up article in May to review how the Dr Strangelove strategy worked. Interestingly, the VIX has already broken the 14 level I discussed above, so this trade has become even more attractive since I started writing this article.
In conclusion, investors have a real world example of the Dr Strangelove VIX investment strategy to follow. The concept is basically to identify periods of time which have an elevated chance of market volatility developing. The investor would then either purchase a long VIX ETF or call options on the VIX index futures at or slightly above key levels, such as 12-14, 20, 30 and 40. Once the trade is placed, sit back and wait like a strategic nuclear submarine awaiting orders. If nothing happens during the targeted period, sell the positions and wait for another time period where the threat level has a potential to become elevated. The key is to place the trade during the calm before the storm. Success is determined by the ability of the investor to accurately forecast the development of coming market storms. Using this VIX strategy is a lot like storm chasing, a lot of boredom waiting, broken up by intermittent periods of excitement, only to go back to the boredom of waiting. While I don't plan to purchase a similar call spread immediately, I will continue to follow geopolitical trends and likely place a similar trade in the near future.
Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Full Disclaimer and Disclosure Click Here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I don't have any immediate plans to place a VIX related trade, but if it falls below 14 I may do so. If it fall to 12 there is a high likelihood that I will.