Trade the Flames of Fear

by Tyler Craig | June 14, 2012 11:05 am

On the surface, the broader market appears to be at a standstill of sorts — a stalemate between stubborn bulls and equally obstinate bears. For all its fury, the last couple rips and dips have yielded little progress, with the S&P 500 Index closing yesterday’s trading session at the same price level as last Wednesday’s session. Though the recent tug-of-war has thus far been much ado about nothing, trouble — or at least the fear of trouble — is bubbling beneath the surface.

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During the past five trading sessions, the CBOE Volatility Index (VIX) is up 15% and the IPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[1]) is up 10%. Whether it’s because of continued angst over the never-ending eurozone drama or more specific fears of how this weekend’s Greek elections will impact markets across the globe, jittery investors have been bidding up the price of SPX options in recent days.

Now, that’s not to say implied volatility is approaching extreme levels, because it’s not. The VIX has a ways to go before reaching the upper Bollinger band, as well as deviating too far from its 20-period moving average. Furthermore, with 10-day historical volatility on the SPX hovering at 21%, it’s not as if a VIX of 24% is all that high. Nonetheless, the recent divergence between the SPX and VIX is interesting.

This could play itself out in one of two ways. The traders bidding up option premiums in the SPX might turn out to be the so-called “smart money,” and their collective actions are serving as yet one more warning sign that another market decline is in the offing. Alternatively, the lift in implied volatility might be unjustified, thus providing opportunity for option sellers.

For those in the “smart money” camp, bearish trades on the SPDR S&P 500 ETF (NYSE:SPY[2]) or short-term bullish trades on volatility products like the VXX are worth consideration. Selling a SPY July 138-143 bear call spread for $70 at these levels provides one high-probability way of playing your thesis.

Traders possessing a more sanguine outlook on the market and who are looking to exploit the recent lift in implied volatility might instead consider bearish strategies on the VXX. One level-headed approach would be purchasing the August 23-18 bear put spread for $300. It offers a potential reward up to $200 — a return of 66% — if the VXX can drop beneath $18 by August expiration.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

  1. VXX:
  2. SPY:

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