Time to Buy the VIX? An Options Strategy

Apr.21.11 | About: Jefferies S&P (VIXX)

The VIX (CBOE Market Volatility Index) hit a year long bottom Wednesday at 14.3. One could wonder if it is simply in a downtrend, which is does seem to be in.

However, if you think that the Volatility Index really measures fear in the market, you must realize that it is still likely to spike soon. There are too many problems in the investment world right now. Yes, the VIX could go down further, but that wouldn’t likely be much further. Instead it is most likely to go up. If you bet this idea to the upside with call options (or call option spreads), you have good odds of making money.

The chart below shows the generally decreasing VIX pattern with reasonably regular spikes upward. Given all the current problems, I would bet on a spike within the next month or two as the Portugal bailout situation and other events unfold.

click to enlarge image

Click to enlarge

You can see the reaction to the Irish bailout was much less than to the Greek bailout. The reaction to the Japanese earthquake, tsunami, and ensuing nuclear reactor problems was larger than to the Irish bailout. One could easily argue that a Portugal bailout will cause still less fear.

However, we are not just dealing with a simple Portugal bailout. There is no government until the elections in early June. The last government was dissolved because it refused to approve an austerity package that was a prerequisite to an EU agreement to a bailout. It is unclear that such an agreement will come easily. Plus, the Finns have to legally get their Parliament to approve the EU bailout action. This may not be easy as the True Finns, a group opposed to the bailout, garnered 19% of the vote in the recent election. It is unclear just how sticky this situation is, but it could be very sticky indeed.

As if the troubles with the Portugal bailout were not enough, the is rampant speculation that the Greeks and/or the Irish may or should be allowed to default (give a haircut to their sovereign debt holders). Any action along those lines could easily become contagious. Even one such action might have a similar effect on the EU credit markets' liquidity that the Lehman Brothers bankruptcy had on US credit markets' liquidity. We know how disastrous that was.

The PIG 10 year bond yields keep going rapidly up. They are up yet again Thursday to Portugal (9.37%), Ireland (10.17%), and Greece (14.76%). This is indeed serious. The line in the sand for a Portugal bailout was supposed to be +4.5% above the German 10 year. It is now approximately. +6% above the German 10 year. It is climbing rapidly. Just a few months ago in December 2010 it was near a 6% yield.

To add to this mess there has been significant trouble in many countries in the Middle East and North Africa. One or more of these could easily escalate in to a major worldwide problem. A major aftershock could hit near Tokyo. Spain, a much larger economy at approximately $1.5T in GDP could come under bond vigilante attack.

I think the way to play this is with call spreads on the VIX. You could buy the 18 May call for $1.75, and then sell the May 21 call for $1.00. You risk $.75 to make approximately $2 more ($2.75). This is less expensive than the June or July options, but it is riskier as the necessary event may not occur within your time frame. You could buy the June 18 call for $3.30, and then you could sell the June 21 call for $2.25. You would risk $1.05 to make an approximate $1.70 more (total $2.75). You get less profit, but the odds of ultimate success are better.

The VIX chart does show spike regularity. It has already gone about 1 month without one. Hence the odds of a spike within the next two months are excellent. For those even more cautious there are the July call options. At that point you will get the benefit of QE2 ending (in all likelihood).

I note that I did StockTalk this suggestion on Seeking Alpha on Wednesday morning, which was perhaps a better time to buy these above mentioned VIX calls.

Good luck trading.

Disclosure: I am long VIXX.