Market Turnaround Strategies: VIX Options

While it's premature to discuss whether or not Congress will pass some sort of bailout package in the near future, it's not too early to discuss ways we can profit if and when the market does eventually stage a turnaround. I know you're tired of me talking about the VIX, but it has been a very good indicator of market climate and had you reduced your holdings according to the VIX levels that I've mentioned in the past (see July 14 blog: The VIX, the Market, and the Investor ) your portfolio would be mostly (if not all) in cash. But you won't need to wait for the VIX to drop below 20 to start investing again, even if your investment philosophy is ultra-conservative. Over the next few days, we'll be looking at strategies that I feel will be the most profitable once the market rebounds. Sure, some of the following strategies are risky, but there will be many that you non-risk takers will find palatable.

First of all, I don't think yesterday's huge drop constituted a market bottom. Why? The unscientific answer is that it just didn't feel like one, and chart-wise, it doesn't look like one, either. During the 2000-2003 tech shake out, the S&P spent over two years in decline putting in five lower lows before forming a triple bottom that marked the end of that bear market. This time, we're only 21 months or so into this decline with the S&P putting in only four lower lows. Of course, the dynamics of each bear market are different, so who knows if we're going to hit another low before capitulation? Although I'm not an economist and can't claim to understand the intricacies of credit swaps, I think we will see at least one more low and I also think that the VIX is going to break the 50 mark before heading back down.

That's the bad news. The good news is that we can spend some of this time on the sidelines figuring out our course of action when the market does recover. Here's a sampler of a couple of plays on the volatility index that you folks with a taste for adventure might want to consider. They're some of the riskier plays I'll be mentioning and unfortunately they do require knowledge of options, so please don't try these unless you know what you're doing.

VIX plays: higher risk options plays
The VIX, the index that measures market volatility, is the only major index that does not have its own tracking stock (ETF). Alas, there are only two ways to trade it—either with futures or options. If any of you want to trade the futures, I'd do so ONLY as a hedge unless you have extensive experience trading this instrument. (If you think options are risky, the leverage on futures is even greater.) For you options enthusiasts, here are a few spread plays to consider:

1. Bear call credit spreads using near-term options (October or November). A bear call spread is one where you sell the lower strike call and buy a higher strike call for a net credit. I'd recommend selling a 35 or 40 strike as the lowest strike and I'd do it ON THE DAY the VIX hits its next high. Remember that your maximum loss is limited to the difference in strike prices less the net credit.
2. Bear put debit spreads using medium term options (December and later). A bear put spread is one where you sell the lower strike put and buy the higher strike put for a net debit. If you're a nimble options trader, the best way to play this one is to leg into it by buying the higher strike put at VIX tops (market bottoms) and sell the lower strike put when the VIX has declined. The reason I suggest a debit spread instead of just buying a plain put is that the spread somewhat mitigates the higher cost of the puts as compared with the calls (because of higher implied volatility in the puts). I'd stick with spreads that have break-even points above 30; more conservative investors should stick to break-even points above 35.

I've found from painful personal experience that it's best to close out an options position when there's little profit left to be had just in case the market does the unthinkable, even if it's only one hour before expiration. When it comes to options, it's much better to be safe than greedy.

In the next few days we'll look at ways of playing other market indexes, sector ETFs, and select stocks.