Profiting From Market Volatility With VIX/ETF Pairs Trades

Sep.18.08 | About: ProShares Ultra (UYG)

During yesterday's carnage, I questioned how I could profit from the irrational, emotional trading that was evident in the markets. Aside from picking up a quick double digit gain on institutional program trading (my assessment based on watching the trading ticks and no news) of a lightly traded stock, I knew there was a volatility play here.

With the uncertainty surrounding (NYSE:AIG) resolved and the market bottoming out at a 4% loss, it was time to act. The VIX (Volatility Index) is a gauge of fear in the market. While you can't trade the underlying symbol, you can trade the options as a hedge or for pure speculation. (NYSEARCA:UYG) is the 2X Leveraged ETF for the Financial Sector. VIX tends to be negatively correlated to the major market indices since it rises with negative sentiment (fear). Here's a chart demonstrating this inverse relationship between the decline in the Financials with the rise in the VIX:

Mid-day, when the VIX was around $34 and UYG was trading at $16.76, I entered into a pairs trade on these instruments. What I was looking to do here was capitalize on the extremes that have been reached and profit on a reversion to the mean. I went long UYG and bought the Oct 35 Calls on the VIX. I couldn't possibly buy puts on the VIX since they were priced at 9.00 at the money. That's right, at the money puts are .75 for the same expiry with at the money call for 9.00 (usually, there's roughly an equal expectation that an instrument will move up or down with roughly the same probability so the puts and calls are virtually similarly priced at the money...otherwise, the instrument would simply trade higher or lower to neutralize this market inefficiency). This is the market telling you there's a mass expectation of return to the mean. So, I was able to get the upside fear calls on the cheap.

Here's how the pairs trade will unfold:

150 UYG@16.76 = $2500
3 VIX Oct 35 Options @ .75 = $225

Scenario #1 - Market Turmoil Worsens - Global Markets Tumble

The thinking is that if there is a complete collapse in Financials (each day it seems a new entity is stress-testing the global financial complex), fear would continue to spike, these VIX options move further into the money and I capture a gain of a few hundred dollars each.

Since I am long the UYG, I could simply await a recovery (it's unlikely the remaining entities like (NYSE:JPM), (NYSE:BAC), etc. will remain impaired forever) and sell shares back. Since the index is now holding primarily the survivors that are picking carrion from the carcasses of financial ruins (Lehman (LEH), Bear Stearns (NYSE:BSC), Merrill (MER) ...Morgan Stanley (NYSE:MS) now mulling a merger with Wachovia and WAMU (NYSE:WM) may be gone soon as well), it's not a stretch to envision that in the intermediate term, UYG will at least remain in the teens (net gain still positive given gains from VIX execution). It's beyond the realm of reasonable scenarios for an entire sector to be wiped out completely. If UYG goes to zero, we're no longer trading anything. So, UYG has a logical bottom. I can't call it specifically, but let's agree it's non-zero. If UYG continues to tank, these VIX options should really rally.

Scenario #2 - Market Conditions Improve - Financials Rally

While this sounds difficult to envision, a near term rally in the Financials isn't inconceivable. In fact, I captured a 1 week 35% gain on UYG earlier in the year when the credit crisis was first unfolding (granted, I should have sold all shares at the peak, rather than the 1/3...can't win 'em all). Since I only paid $225 for the options, it doesn't take much of a rally in UYG (less than 10% move) to more than offset the options outlay. So, under this scenario, once UYG returns to say, just yesterday's level (15% loss today!), I'm already in the money.

Current Return:

Since entering into this pairs trade yesterday, UYG is exactly flat and the VIX has moved up for a nominal net gain of $40. I anticipate that the result if evident in days as to which direction this plays out and I will close the trade.

Am I calling a definitive bottom for the Financials here? No. Do I feel this is a pivot point for either: a) a return to prior levels or b) further deterioration of the financial complex? Yes.

I can profit from a move in either direction.