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Surge In Nasdaq Volatility And VIX/VXN Ratio Implications

|Includes: QQQ, iPath S&P 500 VIX Short-Term Futures ETN (VXX)

Nasdaq closed Friday's session with an almost 7% drop from its recent 13-year highs. This is one of the most severe pullbacks we've seen post Lehman, making investors wonder whether there is a deja vu in the technology sector. The memories of the 2000 dot-com bubble, though not fresh, are still stuck in investors' minds.

This sudden drop has caused an enormous spike in VXN, the index measuring the volatility of Nasdaq-100 index options. VXN is comparable to VIX, with the only difference being that VIX tracks the volatility of options prices on the S&P 500. VXN has increased almost 40% the last month, indicating a surge in fear related to the future of the stock market and, in particular, the tech sector.

Volatility indices are constructed based on the prices of several "out of the money" options. An increase in volatility results in a respective increase in options prices since the writer (seller) of the option demands more from the buyer, so that he is sufficiently compensated for the risk that he takes. Implied volatility is a major determinant in options pricing. Therefore, the recent surge in VXN has led to a parallel shift in the options on NDX making them very attractive for option sellers.

Selling far 'out of the money' (OTM) options is one of the most profitable strategies available, provided that it is employed correctly. The main reason why this strategy is successful over the long-run is that the prices of the far OTM puts are overpriced relative to the implied volatility of the underlying. In plain English, this means that writers of these options receive a premium to sell insurance to the options buyers. This is called 'volatility skew' and it exists in favor of the options writers.

The recent spike in NDX implied volatility has even exacerbated this phenomenon. Specifically, the 5% Delta May Put has an implied volatility of 20% , while the 50% Delta May Put has an IV of 45% . This skewness makes the 5% put selling a 'no brainer'.

The situation gets even more interesting if we compare VXN to VIX. Historically, VXN trades higher than VIX, as the unpredictability of earnings of the tech companies makes the equities more volatile. VXN-VIX divergence is the highest it has been in the last two years, as a sign that the markets are much more worried about a potential collapse in the tech sector than in the overall US economy. Taking into account the mean reverting nation of volatility in general as well, we could reasonably expect that this gap will eventually close.

A more straightforward and maybe less sophisticated play involves ETFs. Volatility tends to drop when confidence among investors prevails and the stock market goes up. A long position in QQQ (ETF tracking Nasdaq) will enable the investor to be well-positioned if there is a drop in Nasdaq volatility. An appropriate hedge in this trade is a simultaneous long position on VXX the most popular VIX ETF. The recommended allocation is 80% QQQ - 20% VXX, so that we will maintain an exposure to the long side. In this way, we will be partially hedged, if the downward pressures on the market turn out to be more severe than I consider at this point.