THE VEXING VIX - HOW IT CAN HELP YOU EARN A PROFIT

Dec. 03, 2013 8:50 AM ET
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Long/Short Equity, Value, Special Situations, Contrarian

Contributor Since 2012

Brian authors the Industrial Strategist. He first earned recognition from the Institutional Investor All-America Research Team in 1999 and he and/or his firm have earned subsequent awards in II along with the Wall Street Journal and Starmine. Subscription requests ($225/year) should be sent directly to subscribe@langenberg-llc.com for the INDUSTRIAL STRATEGIST Wealth Investor Briefing.


Brian has created several industrial sector research innovations including the seminal Multi-Industry Greybook (2001), ROIC based deal analysis, revenue component analysis and business unit trends. Buy side experience includes seven years high net worth advisory work and coverage of 70% of the S&P 500 at various points in time and he built a trade and recommendation track record of +750 basis points, 4X risk budget and a 60% win rate in 18 months at a large state pension. Formerly with Credit Suisse First Boston, Wachovia Securities and Ohio Public Employees Retirement System.


Mr. Langenberg is a former Naval Intelligence officer with deep expertise in logistics, trade, and geopolitics. He made successful contributions in building country studies, expeditionary warfare planning, personnel security and intelligence collection and received the Armed Forces Expeditionary Medal for service during Grenada in 1983. He is a member of the U.S. Naval Institute, Veterans of Foreign Wars (VFW), The American Legion, and the Navy League of the United States.

A proven strategic thinker, leader and mentor, he has turned around a graduate business school, built a high profile speakers program, and currently serves as a Director of Power Source Technologies.

Brian teaches strategy, security analysis and finance at Northeastern Illinois University and also serves in various capacities with the CFA Institute – Chicago as needed and is an adult leader in the Boy Scouts of America.




The CBOE Volatility Index is perhaps the most widely misunderstood, and misused, risk management tool we track. Think of today's installment as a tool safety course. Our macro work includes tracking the price action in a considerable array of currencies, commodities, indexes, securities, and indicators. The secret, which I am sharing with you and which is misunderstood by the majority of even institutional investors, is to understand in advance precisely why we are tracking a particular item, what constitutes a legitimate signal which in turn triggers further analysis and what it does not mean.

Most investors, including the majority of professional investors, believe VIX provides a reliable barometer of market risk.

This is not true. Think of it as GIGO or "garbage in, garbage out." A high or rising VIX usually tells you the market went down already. A low VIX tells you the market has gone up and investors are possibly underestimating risk. The current VIX has dropped (37%) in the past month to about 14, and uses the inputs of implied 30 day forward volatility to suggest that the next 30 days the market probably moves up or down by about 3% to 4%. Unless something happens. That by itself is useless. Since its inception, large spikes in VIX have come after the market tanked.

As contrarians we can profit from this insight. You know the old saw - it is easy to get a loan when you don't need the money and, as well, insurance is cheap when perceived risk is low. When insurance is cheap, considering buying. When insurance premiums are expensive, become an underwriter.

The concepts around VIX apply to options and futures on individual securities as well. Here is a current example.

One idea I've shared with my clients is an investment theme with 400% upside over the next 1-2 years. One of the plays is a stock trading in the neighborhood of $4. When we study the value of that company's assets we find, after stripping out all debt and pension obligations, that the value of this company's natural resource reserves is $44 per share! The "fear" in this sector is high and thus a current holder of that stock would have to pay a big premium to protect their position.

But because we have carefully analyzed the reality we can find multiple ways to profit. In fact, a savvy contrarian investor could, instead of or in addition to purchasing the stock would sell July 2014 PUTS with a$4 strike price and collect about $0.90 of premium (about 22% of the strike price) for only eight months of capital at risk, which is equivalent to selling insurance and earning a 33-35% annualized return. Even though the assets of that company suggest its value is $44 per share, the market is allowing you to underwrite "risk" and capture this 33-35% return, which is ultimately backed by the underlying asset value of the security.

Respectfully submitted,

Brian Langenberg, CFA

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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