The "Striking Price" column in the latest issue of Barron's offers readers two new options trading suggestions. Both involve buying call spreads in the S&P 500 Index (.SPX) (.SPX) and call options on the CBOE Volatility Index (.VIX) . The idea is that, while the S&P 500 is likely to continue trading higher through the middle of 2011, some yet-unknown event -- like a rally in crude oil or the end of the Fed's QE2 program in June -- will cause market volatility to spike as well. So the author suggests taking a long position in VIX calls and a bullish position in SPX call spreads. Let's take a closer look at this idea.
The CBOE Volatility Index and the S&P 500 are related in a very important way. VIX tracks the expected volatility priced into S&P 500 options and is very sensitive to movement in the overall market. It's sometimes called the "fear gauge" because the VIX tends to rally during times of chaos and panic on Wall Street. For example, VIX hit a multi-month high of 31.28 when the Japanese earthquake and nuclear crisis dominated the financial headlines on March 16. The panic has subsided, and VIX has eased back to 18.
In the Barron's piece, Steven Sears wants readers to buy call spreads on the S&P 500 and also buy call options on the volatility index. By doing so, the investor is making both bullish and bearish market bets. That is, he is betting that the S&P 500 will move higher, but by purchasing calls on the VIX, he is also bracing for a spike in the fear gauge, which is only likely to happen if the S&P 500 moves sharply lower. The first trade:
Buy June 132 calls on the SPDR S&P 500 (SPY) that traded at $3.36 when the SPY was recently at $130.15. If the cost of the SPY call is an issue, you can lower the price, and limit your profit, by selling the June 137 calls for $1.25 to reduce the cost to $2.11. ... To profit from a temporary stock-market decline, consider buying the VIX May 19 call that cost $3.50 when the fear gauge was at 18.24. Buyers of the May 19 call double their money if VIX trades to 26.
Since SPY is the exchange-traded fund that holds the S&P 500 names, buying a call spread on the ETF is the same thing as buying a bullish spread on the SPX cash index itself. Sears expects the market to perform well through the June expiration, but suggests that readers also " buy VIX calls in case volatility pops higher due to another event, like oil prices rising above $120 or another earthquake tremor in Japan, which would likely cause the stock market to pop lower." Similarly, the second trade is to:
Buy the May SPY 132 call, which cost $2.72 when SPY was at $130.64. If you want to lower the cost, sell the May 136 call that was recently at $1.01. ... To profit from stock weakness around QE2's end, buy the VIX June 19 call in anticipation that the stock market will tumble lower when the easy money ends.
The expiration dates are different in the two trades, but the idea is the same. In the first, the investor is buying the SPX June spread and buying VIX May calls. In the second, they're in the SPX May call spread and VIX June calls. Therefore, if you expect the market to rally from May through June, the first trade is better. If you expect, the market to sell off between May expiration and June expiration, the second trade is better.
The greatest risk from the trades is time decay. Because VIX options expire on Wednesdays, the May 19 calls have 50 days of life remaining. If you pay $3.50 a contract and VIX doesn't settle about 19, then the contract will expire worthless and you lose the entire investment. The trick is probably to sell into any VIX spike, because -- as we have seen over the past 10 days or so -- VIX can quickly revert back to a normal range. The index is down 42% from the March 16 highs.
Also, VIX options are not based on the spot or cash VIX. They're based on forward prices for the volatility index, and there is no guarantee that a longer-term contract will increase in value if the spot VIX moves higher. (To get a sense of VIX forward prices, you can take a look at VIX futures at cboe.cfe.com). According to the CBOE,
VIX option prices should reflect the forward value of VIX, which is typically not as volatile as spot VIX. For instance, if spot VIX experienced a big up move, call option prices might not increase as much as one would expect. Depending on the value of forward VIX, call prices might not rise at all, or could even fall!
So, even if the market corrects by 5% or 10%, if the decline is orderly, there is a risk that the VIX May 19 or June 19 call option wouldn't see a dramatic increase in value. Meanwhile, if the market moves lower or trades sideways, the SPY June 132-137 call spread or May 132-136 call spread will lose value and potentially expire worthless as well.
In conclusion, if the strategist is buying out-of-the-money calls on the VIX and out-of-the-money call spreads on SPY, the idea is that the market will move higher but could see a sudden move lower in the short term. In the meantime, since the contracts are out-of-the-money and consist of nothing but time value, the strategist will be fighting the negative impact of time decay in both the spread and VIX calls. The greatest risk is that all of the options expire worthless, which will happen if the market stagnates, trends slowly, or moves sideways. It seems that if the strategist really expects to see a spike in market volatility during a bullish market, it would be better to simply buy VIX calls then sell them into any spike in market volatility and reinvest the profits in the SPY call spread. Or, one might buy the SPY call spread and avoid the risk of holding VIX calls in a bullish market.
But of course, that's just one guy's opinion. Only the market action over the next few months will determine the success or failure of the trading idea.
On March 31, TheStreet's OptionsProfits is hosting a webinar featuring Andrew Giovinazzi of Aqumin. Using specific trading ideas, Andrew will discuss how to pick the right strategy for your risk tolerance and overall portfolio. We will address how to formulate the proper trade, manage the position and make adjustments and exit strategies.
OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.
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