The stock market closed out the year in quite the explosive fashion. While the S&P 500 rallied 1.7%, the most impressive showing came from the small-cap-laden Russell 2000, which soared 2.17%, on high volume to boot. No doubt the surge was led by increasing optimism that a deal to avert the fiscal cliff would finally pass.
Perhaps the most powerful move of the day, however, was the action in the volatility space.
Click to Enlarge Leading up to Monday’s trading session, the fear and angst surrounding the fiscal cliff drove the Volatility Index (CBOE:VIX) to levels not seen since June. The extremity of the move is captured in the accompanying chart, showing the VIX had risen far outside the upper Bollinger band.
And so, amid the year-end buying bonanza, volatility expectations returned from their lofty heights, driving the VIX down 20% on the day.
While the fact that the VIX finally experienced some mean reversion might not be that surprising for us volatility watchers, the speed and magnitude of the drop still was a sight to behold.
Alongside the VIX waterfall, the ever-popular iPath S&P 500 VIX Short Term Futures ETN (NYSE:VXX) plummeted 10.22% on its highest volume ever. The sharp reversal illustrates once again the difficulty of buying VXX as a hedge against a falling stock market — or at least the need to exit bullish VXX positions quickly if Armageddon doesn’t arrive and a market rally ensues.
Click to Enlarge If you believe Monday’s move was the real deal and a new up-leg is upon us, consider selling February put spreads on the Russell 2000. Of the major market indices, the RUT is without a doubt the healthiest. It was able to escape the fiscal cliff drama with bullish trend soundly intact. The recent selloff halted at the rising 20-day moving average and put into place yet another higher swing low.
You could sell the Feb 780-770 put spread for a $1.10 credit or better. The max reward is limited to the initial $110 received while the max risk is limited to $890.
To reduce the risk if the uptrend in RUT reverses, consider closing the position if we break the support zone around $827.
As of this writing, Tyler Craig held neutral positions on RUT and bearish positions on VXX.
