Strategies for Increased Market Volatility

When traders and investors turn largely bullish, they decrease buying protection to hedge their bets against market declines. They become 'complacent' and market volatility falls. A visible account of this complacency and lack of volatility can be seen in the VIX - generally considered a 'fear index' on the US S&P 500 stocks. Reviewing the slightly downward sloping support line for the VIX on the five year chart below, we see the VIX recently traded at levels not seen since before 2007. Although a very bullish sign for the equity markets, these levels are unsustainable. Therefore, we are currently interested in providing our clients exposure to a positive move in the VIX representing higher volatility and lower equity prices.

We have three trade opportunities in development. The lowest risk, longest term play is a 'managed certificate' that trades the moving average of the VIX with either a long or short bias. In general, this is a great way to hedge a bullish (or 'long') equity portfolio. This certificate trades the VIX 'short' almost 80% of the time, so its value increases as volatility falls. However, when the 4-day moving average of the VIX moves higher, the certificates allocation changes from a short bias to a long bias. This means that spikes in the VIX would be captured as gains also.

A more aggressive and timely opportunity would be selling a VXX put (within an decreasing autocall note). VXX is an index ETF that aims to track the movements of the two front months of VIX futures. Selling a put is a bullish position that enables investors to get paid a premium as long as the price of VXX does not close below the strike price of the put option. With VIX and VXX at all time lows, a timely sale of far out-the-money puts on VXX can yield an easy 15%+ annualised rate of return. This is a not a long term holding strategy to hedge a bullish portfolio, but a rather safe bet at making a good short term trading return.

Finally, we are evaluating a 2X leveraged mini-future March 2013 contract with a stop-loss. With VIX extremely low now for an extended period, we are consciously practicing patience while we wait for the first signs that SPY is about to roll over. We find this strategy enticing for investors who want a direct play on the VIX with a leveraged move. Again, looking at the graph above, when the VIX moves up it moves in leaps and bounds! Today alone the VIX was up over 5% on a flat trading day in the markets. Imagine what would happen if market volatility really returned with vigour. Trade size is especially important with this type of product, so we are working to get this product to clients for as little as USD 10,000, with daily liquidity, transparent pricing and the ability to scale into and out of this product.

For information on this note, and others that can hedge a bullish equity portfolio, follow us on Facebook or sign up for our structured product mailings.

Author: Chris Davies  

Posted in: auto call , SPY , VIX , Volatility , VXX