Buy VIX Calls When They Are Cheap

| About: iPath S&P (VXX)

The market volatility index VIX is said to measure the fear in the broader market, indicating whether the market has become complacent or panicky.

In August 2011, VIX started spiking to levels reminiscent of the 2009 financial crisis. Between August and October 2011, VIX traded towards the high end of 25-45 range. This year is different though.

The Weird VIX Movement

Take a look at the table below. On August 02 2012, the S&P 500 closed down from the day's open and yet VIX dropped significantly from an open of 19.05 to 17.57.

VIX and S&P 500

"Believe Me, It Will Be Enough"

On August 02, Mario Draghi, the president of the European Central Bank, had provided reassurance regarding the eurozone, much to the relief of U.S. investors. In fact in the last week of July, Draghi went out of his way to give an unexpected "pledge" that the ECB will do "whatever it takes" to save the euro. An astonishing aspect of this announcement was the almost rhetorical sounding assurance that he went on to add; he said, "Believe me, it will be enough".

Between then and August 2's ECB announcement regarding the rates (although ECB did disappoint some by not reducing the rates, the overall market was not really expecting a rate decrease at this point), worries about the eurozone mess have slightly eased. I believe that this has had a big impact on the VIX.

Economic Data - "Not Bad"

Earlier on the last day of July, before the slew of economic data was about to hit us, I had discussed the importance of the upcoming economic indicators on market movements.

No big news came out of FOMC meeting, but apparently there was some relief that there was no mention of the dreaded Fiscal Cliff (yet). Also, ISM Manufacturing data came out neutral-to-positive. The best was the jobs report though - the Bureau of Labor Statistics announced an increase of 163,000 in non farm payrolls. According to this report, employment rose in professional and business services, food services and manufacturing.

The obvious knee jerk reaction to this data is that the S&P 500 shot up 1390, and the market suddenly now sees a reason to remain positive in the short term.

Net Effect: VIX gets crushed

After a bad first week of these same economic indicators in July, the market was understandably under pressure at first, however, August has started with a bit of a bang. The net effect of Draghi's assurances and the economic data is seen in VIX's drop on Friday. On August 3, the volatility index plunged to a close of 15.8. Investors are suddenly in a risk-on mood.

Next Steps - Near Term

In the past few months, VIX has traded towards the low end of the 15-25 range. My opinion is that this is a good time to buy August or even September 2012 VIX calls, for strike prices in the range of 19-22. One may even choose to sell same dated calls at higher strike prices to collect some premium (hopefully on a day when VIX spikes though). If you are not into options, buy VXX but remember to never hold any ETNs related to volatility for long.

As far as trading this market goes, my personal opinion is to not initiate new positions "hands over fist" this August, and rather wait for severe pullbacks as we march through the third quarter.

The entire premise of this opinion is based on a variety of factors:

  • I expect the market movement in the next couple of months to be heavily dependent on key economic indicators relating to housing, construction/industrial, consumer spending and employment, and this data has so far shown slow improvement but has not been too consistent. Any hiccups on the path to recovery could cause substantial panic in the markets.
  • Secondly, there is this issue of the Fiscal Cliff that seems to be slowly and steadily snowballing towards us, getting bigger as we move closer to the elections and year end.
  • Also, the eurozone mess is for here to stay for a longer time than we think - Draghi and Merkel have to back their words by actions, and the more they say about their actions "being enough", the higher the expectations from the market.
  • And last but not the least, historically, September is the worst month for most indices on an average (not every year though). One may argue with this point that history does not always repeat itself in the stock market, but my thinking is that if it does not always repeat, it rhymes often.

If we do see a mini-rally in August, time would be ripe to take some profits out of your speculative positions.

Next Steps - Long term

For long term plays related to recovery, investors should not panic if the market heads downwards, and they should not sell at unnecessary losses. Many aspects of the fiscal cliff can be avoided as the Congress will be able to step in with a clearer view post-Election.

Going into the 2012 year end and even next year, I remain a believer in the overall recovery story, despite the monthly distractions such as the economic indicators, the anticipation drama put forth by the Marios and Bens of the world and the doomsday scenario talks of the Fiscal Cliff.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am long Aug 22 VIX Calls (also sold Aug 25 VIX calls) and may repeat this trade mid-August for Sept expiration.