Last week the market rallied hard, sending the S&P 500 up more than 8% from its November lows. As stocks rallied, volatility plummeted.
On Wednesday, the Chicago Board Options Exchange’s Volatility Index (CBOE:VIX) put/call ratio fell to a low of 0.13. An extreme low like this is generated when there is heavy put selling and lots of call buying.
We like to use put/call ratios as a contrarian indicator; extreme lows imply a short-term floor in the market, while extreme highs imply a short-term ceiling.
Typically when volatility rises, stocks fall. Therefore we want to use the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX), to both benefit from a rise in volatility and simultaneously protect a long stock/short option portfolio from a market correction.
We recommend buying the VXX Jan 44-46 bull-call spread because of the favorable risk/reward ratio the spread creates. This means buying to open the VXX Jan 44 Calls while simultaneously selling to open the VXX Jan 46 Calls.
Prices that work right now are paying $4.80 for the long $44 calls and collecting $4.20 for the short $46 calls, for a net debit of 60 cents. But it doesn’t matter what you pay/collect for the individual legs of the trade, as long as you enter in the 60-cent neighborhood for the entire trade.
Should VXX close above $46 at January expiration, the trade returns over 200%, which will help buffer losses in long stock positions. If VXX does not rise before January expiration, the trade only loses 60 cents. The idea is that the losses are small enough to be absorbed by gains from long stock positions in your portfolio.
Here’s a summary of this trade idea:
Stock Price: $41.75
Option Play: Bull-Call Spread
Sell: Jan 46 Call @ $3.20
Buy: Jan 44 Call @ $3.80
Net Cost: $0.60 = $4.80 – $4.20 (Long Call – Short Call)
Breakeven: $44.60 = $44.00 + $0.60 (Long Call + Net Cost)
Max Profit: $1.40 = (46-44) – $0.60 (Spread Width – Net Cost)
Max Loss: $0.60 (Net Cost)