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Why a big bet on the VIX announces tough day ahead for the market

|Includes: Orange (ORAN)

An interesting article on CNBC mentionned a interesting bet on the VIX :

One trader on Thursday bought 20,000 July VIX calls at the 45 strike and sold 55 strike calls for an overall premium of 42.5 cents in a trade that cost about $850,000 to execute. The net impact is that the VIX would have to beat the 45.42 level by the July expiration for the investor to make money. The VIX hasn't been past 40 since April 21. (source : CNBC)

The VIX reflects the market volatility. At the worst of the crisis, in October-November 08, the VIX reached an all time high above of 89,53. During the market sell off in February-march, the VIX moved from 39 (mid january) to 52 (early march). Right the VIx is moving in a range between 27-32 (last time we were in that range it was just before Lehman Brother Bankruptcy.

So what means this huge bet ? If it happens to be a good bet, it means the market will have a very tough moment in july and will be face a big correction. That correction doesn't shock me as i believe that, in order to build a real bottom, the market needs to retest some intra market low. I guess the market should retest either the october or november low to really look at a market bottom.

This bet on the VIX means that some deep pocket investor think it will happen during the summer, as if the market retest the low, we should expect a major spike on the vix. I would also like to point out to the fact that the VIX double when the uptick rule was cancelled in July 07, as everyone expects that sooner or later the uptick rule will be reinstated. It wouldn't surprise me to see a big correction and a major spike on the VIX before the reinstatement and i believe the option traders believes the same.

Now, what should you do if this correction happens or if you feel a correction will happen ?

As a long term investor, i believe you have some picks you like over the long term, if you are a growth player they are probably volatility pick, whereas if you are a defensive player, you are looking more at defensive stock that pays solid dividend.

I would do this :

- Growth player : Choose the stock you like, and sell cover put month over month. As you expect to buy the number of shares you sold on the put, if the strike price is reach, you will purchase the stock at a price you liked over the long term. If the strike price isn't reach, you will have the premium from the put and in addition to that you will also either choose to buy now the stock or sell the cover put of next month if you still believe the market will drop.

- Defensive player : You are looking for defensive stock with regular long term dividend paiment. Those defensive stock didn't had great day during the rally as mainly speculative and growth stock moved up. I guess you could already take your position early as if the market pullback, we should expect a still solid performance from those defensive stock as they didn't really follow the market rally. You would at the same time secure an already solid yield. Now if you still think that if the market retest some low you have a big drop on those stock. Apply the same strategy, sell cover put.... By the way, i would advice dividend player to pick France Telecom (FTE) that offers a very solid long term dividend and as a very strong organic growth and generates a lot of cash. It is a very solid dividend pick.


Disclosure : Long FTE