Barron's ran an

article yesterday

suggesting that investors take bullish trades on the

CBOE Volatility Index

I:VIX

to hedge short-term market risk. The idea is simply that market volatility will increase if the stalemate in Washington continues, the debt ceiling isn't raised, and credit agencies downgrade the US triple-A credit rating. In the piece, author Steve Sears suggested an October call spread on the volatility index. Let's break the trade down and analyze it in a bit more detail.

VIX is sometimes called the market's "fear gauge" because it tends to spike during times of panic and mayhem on Wall Street. The index tracks the expected or implied volatility priced into S&P 500 Index (.SPX) options. Consequently, when there is a surge in demand for SPX put options to protect portfolios, the contracts become more expensive and the VIX will move higher to reflect the increased options premiums. The volatility index hit its highs of the year of 31.28 after the Japan quake, concerns about the economy, and worries over the European Debt Crisis.

VIX is currently trading up 1.38 to 21.11 midday Wednesday and has rallied 23.2% on the week. The market's fear gauge started climbing Monday morning after politicians failed to make any strides in breaking the stalemate over budget plans. The bickering in Washington is raising concerns about a possible downgrade to the US triple-A credit rating heading into the August 2 deadline to raise the debt ceiling.

To profit from further market volatility, Barron's suggests initiating a bullish spread on the VIX.

TheStreet Recommends

"Investors who are afraid that the debt-ceiling debate will linger beyond August expiration can consider buying VIX October 21 calls and selling VIX October 24 calls. The position cost $0.95 when the VIX was at 18.91. Investors earn a maximum of $2.05 when the VIX is 24, or higher, by October expiration. In addition, to protect the portfolio through Washington's debt-ceiling debate, the October VIX calls provide protection during September, which is traditionally the most volatile month on the trading calendar."

To initiate the spread, the investor might buy October 21 calls on the VIX for $3.50, sell October 24 calls at $2.55, and pay a $0.95 net debit on the spread, as suggested. The risk is the debit. If VIX settles below 21 at the October expiration, the calls expire worthless and the debit is lost. On the other hand, if VIX rallies beyond 24, the calls are in-the-money and the spread is worth $3. Since 95 cents was paid, the profit is $2.05. The nearby optionsXpress payoff chart also shows that the breakeven at expiration is at $21.95, which is the strike price plus the debit (commissions excluded). Importantly, the spread can be closed out any time prior to expiration.

VIX has moved up from 18.91 to 21.11 since the trade recommendation was made on Tuesday, but as we can see from today's options prices (chain below), the spread has widened to only $1. In other words, VIX has rallied 11.6% and the spread has widened by only $0.05. After transaction costs, there is little profit so far - despite the fact the volatility index has made a significant move higher.

The reason the spread has not widened significantly is due to the fact that VIX options are not based on the volatility index itself. The underlying security for VIX options is a forward value of volatility index at expiration. For example, options expiring in October 2011 will be based on SPX options expiring 30 days later, or November 2011. "The forward value is estimated using the price quotations of SPX options that will be used to calculate the exercise settlement value for VIX on the expiration date," according to the Chicago Board Options Exchange.

Simply stated, VIX options are based on what volatility will look like in the future rather than actual volatility today. VIX futures quotes on the Chicago Futures Exchange web site can give you a sense of forward VIX prices. While the spot index is up 1.38 to 21.11 today, VIX October futures have added just 0.35 to 22.15.

The key to success in initiating the October 21 - 24 call spread on the volatility index is for the index to continue climbing and to remain higher over the next few months. Obviously, if volatility falls during that time instead, the trade will lose money. On the other hand, a very large and substantial spike in market volatility in the short-term will probably cause the spread to widen and result in an opportunity to exit the trade at a profit. The key is for both the spot VIX and forward prices to move significantly higher. If not, the success of the trade will hinge on volatility perceptions heading into the Fall. In other words, by initiating the spread, you're really betting that volatility will be high in October and November, rather than August and September.

At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.

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Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.

In addition to writing market commentary and trading-related books and articles, Fred has also worked as an instructor, educating investors on advanced topics like measuring volatility, the benefits of sector rotation and the risks and potential profits from trading around earnings. An active trader himself, with over 15 years securities industry experience, his market observations and analysis of the options market are featured regularly in the financial press including Barron's, Reuters, The Wall Street Journal, and Bloomberg.