Buy VIX Calls for Cheap Protection

by Daniel Putnam | January 15, 2014 12:54 pm

Those in the market for trades with a favorable risk-return profile need look no further than options on the CBOE Volatility Index (VIX[1]). With the VIX currently at the bottom end of its range of the past year — and far below its historical average — it’s time to protect your stock-market profits with some cheap insurance via VIX calls.

A Favorable Risk-Reward Trade-Off

The case for owning volatility here is straightforward: There’s far more latitude for the VIX to rise than there is for it to fall. At its level near 12 in Wednesday morning trading, the “fear gauge” appears to have limited downside. Even in the salad days of 2005-06, the index flatlined around 10 even as the market rallied more than 20%. This demonstrates how the VIX becomes “stickier” near single digits than it does at higher levels. After all, option prices always need to incorporate some element of volatility, however small.

Another reason why the VIX may be approaching near-term support is the technical picture, with the current chart showing healthy support near 12:


At the same time, the VIX has plenty of room to run to the upside. In the past year, a drop near 12 has generally been followed by quick moves up to the 16-18 range. One reason for this is that once the VIX falls this low, it doesn’t take much in the way of adverse headlines for the index to bounce higher.

Traders would make money by buying VIX calls here even with this type of modest rise. A larger market downturn that brings the VIX closer to the 20-22 range would be an added bonus that could turn a purchase of VIX calls into a very profitable trade.

VIX Options to Consider

Playing this risk-return scenario with VIX options doesn’t cost much. For example, the bid-ask on the March 13 Call stood at $2.50 x $2.60 on Wednesday. In the short term, this option would provide a roughly 100% return if the VIX moved to approximately 15 — which is certainly in the realm of reason. For those willing to pay a little more to give the trade more time to play out, April 15 Calls could be had for $2.15 x $2.25, which would also double in value with a near-term move in the VIX to about 15.5.

Keep in mind, of course, that the longer the trade takes to work, the higher the VIX needs to go to for options to achieve this type of heady return.

The Role of Historical Volatility

It’s true that the depressed VIX is largely a function of the extremely low level of historical volatility in the past year. Other than a blip following Ben Bernanke’s first mention of  “tapering” in the spring, the market has largely enjoyed a steady upward trajectory with no corrections of any significance.

However, assuming the VIX stays low from here assumes that the news flow remains positive and that the market continues to move higher without even a modest correction. With valuations becoming more extended — and continuing to rise faster than earnings — the odds of that scenario are growing smaller with each passing week. In this regard, it makes sense to purchase insurance with defined downside risk.

Are VIX ETFs the Answer?

Some readers may ask why it makes sense to use options when there are so many VIX ETFs that provide the same level of protection.

The simple answer: They don’t.[2]

Funds such as iPath S&P 500 VIX Short-Term Futures ETN (VXX[3]) have proven to be very inefficient ways to play the direction of the VIX, since the need for the funds to roll continually into more expensive, later-month options leads to persistent downward pressure on their price. VIX options certainly have an element of decay — in this case time decay — but it tends to be more predictable (and therefore more manageable) than the tracking error found in the VIX ETFs.

VIX options are also highly liquid, which keeps spreads relatively tight.

The Bottom Line

VIX options certainly aren’t for everyone, and they represent several layers of derivatives away from holding an actual ownership stake in S&P 500 companies. Still, the current level of the VIX argues for active investors to capitalize on low implied volatility by protecting their portfolios at attractive prices.

After all, the time to buy flood insurance is during a drought.

As of this writing, Daniel Putnam owned VIX calls.

  1. VIX:
  2. They don’t.:
  3. VXX:

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