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More Volatility or is the Market Stabilizing? An Options Look and Strategy

|Includes: DIA, QQQ, SPDR S&P 500 Trust ETF (SPY), SPY, VXX, VXZ

With the VIX closing below 30 (historically high level) as of Friday May 29, 2009, it looks as if the market is starting to settle down. The VIX shot above 30 on September 15, 2008 and has stayed above it (closing value) ever since. The VIX closed below 30 three times in May; on the 19th, 20th, and last trading day the 29th. The VIX also closed below 30 for every day in June. However, as of 1 PM EST. today June 3, 2009 the VIX is back above 30.

A similar trend can be seen: after closing at 29.03 on May 20th it quickly got back above 30 and closed above 30 until the 29th, where it closed at 28.92. If we can stay below 30 and eventually move lower, I believe it will attribute to the overall confidence in the market, and push the market higher. Looking at the chart below, we can see that the last time the VIX closed below 30 was on September 12, where it closed at 25.66, this correlates to the S&P 500 at 1251.70.

I am not saying that because the VIX closed at 25.66, the next time we hit that level the S&P will magically be at 1270. However I am stating that it should attribute to a market rally. The chart above shows the VIX (red and white) and the S&P index (green), and as you can see is almost perfectly negatively correlated. As the VIX gets higher the market sells off, and as the VIX drops the market rallies (this should make sense).

Historically entering the summer months the market does not perform as well as the other months, however if the VIX could stay below 30 and get lower, it may help to keep the rally going into fall.

Using Options to predict the probability the VIX is below 30:

As posted on my blog about VIX options, we can see that the options market is factoring in a 61.1% probability the VIX closes at or above 30 by June expiration (all data as of 1 PM Wednesday June 3, 2009). If we go out to July the options market is factoring in a 60.8% chance the VIX will be at or above 30 at July expiration.

Below is an options strategy I use to hedge against volatility:

One way I hedge against volatility is to purchase call contracts on the VIX. I am currently in a 35/37.50 option spread (learn more about options here) for the July expiration. If opened as of now, my cost would be $85 per contract with a 44.1% chance it'll return almost 200% profit.

Disclosure: Long VIX July 35/37.50 Spread