Tuesday, July 15, 2008

VIX Plays

Yesterday we delved into the mysteries of the VIX looking at it from an historical perspective and what it portends for the market. I also tossed in my two cents concerning ways to play the market when the VIX hits various levels, saying that a rise above 30 generally signals that a market turnaround (even if it's a short-lived one) is imminent. Well, earlier this morning the VIX did rise above 30. As of this writing (about an hour before market close), the major market indices look to be forming bottoming tails--another tell-tale signal of market reversal. So, the question of the day is: how can we make a quick buck from a market reversal? Let's review some of our options.

The Set-Up
Being a scientist and mathematician at heart, my favorite intellectual pastime is to play variations on a theme of “What if?” Today's hypothesis goes like this: “Let's suppose the market will turnaround, either tomorrow or in a few days. How can we best profit from an upturn?” Well, we can either buy index tracking stocks such as the Diamonds, the Spiders, or the Qs; we can employ some sort of bullish index option strategy such as buying long calls, selling puts, or putting on bullish spreads; or we can use the reverse options strategies on the VIX which also has liquid options. To guide us towards the correct answer (or answers), we need to look at what would have happened in previous similar scenarios. In science, the more data you have the more accurate your results, but since I don't have a staff of lackeys to cater to my every whim, I'll have to make do with selecting one previous scenario, and the one that I've selected is the last one when the VIX hit 35 on March 17th. This was also the day the S&P 500 (as well as other major markets) put in a bottom and reversed course for the next two months. Now two months is a relatively long time for a bear market rally. Going back further to the previous two VIX 35 events that occurred last August and this January, you'll see that the market corrected for only a week to ten days. So, what I'm going to do is use seven trading days (weekends not included) as my holding period.

Stocks or Options?
For simplicity, let's look at the following scenarios:
1. Buying the tracking stocks on the Dow, the S&P 500, and the Nasdaq 100: DIA, SPY, & QQQQ
2. Buying call options on the above tracking stocks
3. Buying puts on the VIX

That's the setup. The following table shows the results.
[Note: Commissions are not included. End of day prices were used. Annualized returns based on 251 trading days (this is accurate to within a day or two. I'm too lazy to count the number of trading days this year.)]

I know I've gone through a similar exercise before but I wanted to do this again to see how put options on the VIX would compare and you can see that the results aren't nearly as good as using call options on the tracking stocks. It seems that you'll get the most bang for your buck by playing the Qs, either by buying the stock or the at-the-money options. Remember, too, that there's more leverage involved with options meaning that you don't need nearly as much capital to make a similar return. (See the example below.*) So, if you're interested in potentially making a quick buck, set an alert for when the VIX hits 35 and enter your play. Just remember to exit within a week or so if you're using short-term options as any longer than that and you'll start losing money due to time decay.

Viva la Vix!

*Example: Options vs. Stocks--The advantage of leverage
Let's say we have $1000 to make a trade. Using the data for the Qs in the above example yields the following results (assuming no commission costs):
Stock (QQQQ)
Initial cost on 3/17: 24 shares x $41.48 = $996
Sell price on 3/26: 24 x $44.70 = $1073
Net Profit: $77
Option (QQQQ June41 Call)
Initial cost on 3/17: 3 contracts x $3.19 = $957
Sell price on 3/26: 3 contracts x $5.14 = $1542
Net Profit: $585

You can see that options return more than seven times that of the stock.

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