As a result of the sharp rally in stocks in recent weeks, the implied volatility of options on the S&P 500 — as represented by the CBOE Volatility Index, or the VIX — has come crashing down to the tune of more than 40%.
Only a few weeks ago, the VIX was in the high 20s, but the risk-on move has brought it down into the teens. Over the next two weeks we will hear from the European Central Bank, the Bank of Japan and the Fed. While stocks could rally right through these likely dovish central bank statements, buying some protection with a bet on the VIX could now be a smart move for active investors.
Late last week, I shared this idea of buying some calls on the VIX with my clients. Several clients then asked me why I am looking to make a bet in higher implied volatility as opposed to buying put options on the S&P 500, which are also attractive. I explained to my clients that while all scenarios are possible, if I am correct that we remain in a corrective phase for stocks, then before stocks turn lower again, implied volatility should see see a bid as smart money takes the other side of the crowd and buys protection.
In other words, while stocks could see somewhat further highs in the immediate-term, if the VIX wants to continue making marginal higher lows, then it should start seeing a bid creep in here very soon.
In the hedge fund and trader circles that I travel, we often discuss that making a bet on implied volatility or the VIX can be easier than making a bet on the direction of a market.
VIX Charts
With that in mind, let’s look at the multiyear weekly chart of the VIX and note that the spike last August that pushed it into the low 50s (a rare occurrence) also signaled the arrival of a higher-volatility environment for stocks.
We also see that the VIX bottomed in the summer of 2014, which is when commodities began a more volatile period. Commodity volatility tends to precede equity volatility, and in that sense, the VIX making a series of higher lows since summer 2014 was a leading indicator of higher volatility for some of the smart money crowd.
On the daily chart, we see a more defined line of higher lows on the VIX since last summer. Furthermore, the recent correction in the VIX has brought the MACD momentum oscillator into oversold territory. Options on the VIX are now trading at implied volatility levels last seen in July 2015 and are thus reflecting a relative bargain — if my underlying assumption of higher volatility ahead holds true, anyway.
Active investors and traders could now look to buy some May 20 strike call options for around $2.80, using a stop loss of 15 on the VIX and an initial price target in the 20-21 area.
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