Hedge Volatility (VIX)

Brian Hicks

Updated August 16, 2011

“Buy when there’s blood in the streets, even if the blood is your own,” once said Baron Rothschild.

He should know. He made quite a fortune in the panic that followed the Battle of Waterloo.

Rothschild cast aside the negativity in times of extreme pessimism — just as we have a chance to do today for the long term.

As doom and gloom run amok, scared investors are sending volatility through the roof.

Volatility can certainly defy gravity for awhile longer, but chances are good it’ll top out and reverse to the mean very soon.

You can’t be afraid to short it long-term — even if the herd suggests the opposite.

In the days following the “downgrade heard ’round the world,” VIX ran to a high of 48. That’s overdoing it. There’s only been a handful of other times it managed a read above 45.

The VIX ran to a high of 89.5 during the 2008 financial crisis in October of the same year.

But typically — even in some of the worst of times it’s peaked right around 50:

  • The VIX ran to 49.53 in October 1998 on the Long Term Capital Management Crisis.

  • It ran to 49.35 after the 9/11 World Trade Center attacks.

  • It ran to 48.64 in October 1997 on the Asian financial crisis.

  • It ran to 48.46 in July 2002 on the tech crash.

  • It ran to 48.20 in May 2010 on the European debt crisis.

  • And it ran as high as 48 during the current U.S. debt rating downgrade/credit crisis.

In the wake of many of those, you could have cashed in quite nicely as volatility dropped and the markets surged:

vix chart1 081511

Are we confident it’ll happen again?

Near term, not so much. We’ve got the Merkel-Sarkozy meeting to avert a growing debt crisis on deck this week, along with reads from the Philadelphia Fed, CPI and PPI reads, existing home sales, leading indicators, housing starts, and building permits.

And there’s great doubt a European debt deal can get done to prevent insatiable volatility in the near term…

Longer term, though — as fear reaches its pinnacle when the VIX drops, it’ll drop hard.

Look at What the R-4 Trigger Found

I’m sure you remember the R-4 Trigger. The same principles apply in this situation.

Every single time the VIX traded above the upper Bollinger Band, it pulled back hard. The same is likely to happen with the VIX nowadays.

Plus, every time the Williams % Range agreed with the MACD and DMI reads, the VIX dropped.

While MACD and DMI don’t agree these days, a move above the upper Bollinger Band and an overbought read on W%R sent the VIX from a high of 48 to less than 35.

Check out the chart:

vix chart2 081511

The Best Way to Trade

Hedge by playing the iPath S&P 500 VIX Short-Term Futures ETN (VXX) underlying with a hedged short.

If you want to make some serious money, buy the iPath S&P 500 VIX Short-Term Futures ETN (VXX) December 2011 32 put (VXX111217P00032000), while straddling (or hedging) with the December 2011 32 call (VXX111217C00032000). 

Say volatility spiked again this week, which it could…

We’d walk with 15% for every $1 the underlying VXX moved up. And we’d walk with ~15% to ~20% for every dollar the underlying moved down.

If you did that with a short, you’d walk with maybe 9% if VXX fell to $30.

You’re just playing both sides by buying a call option and a put option on the underlying stock. That means you’re covered if the stock falls or rises.

Both call and put would also carry the same strike price and expiration date, as detailed above.

Look, I understand that not all of you are comfortable using options… and that’s okay. But it’s the absolute best way to turn a monstrous profit here especially in extremely volatile markets like these.

Stay Ahead of the Herd,

Ian L. Cooper
Analyst, Wealth Daily

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