Make Market Volatility Work for You

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

The New York Sun

Do the ups and the downs of the market give you heartburn? Here’s good news: You can take advantage of those gyrations by trading the VIX index, known as the “fear gauge,” one of the fastest growing games in town.

Over the past year, you may have heard hedge fund managers moaning about the lack of market volatility. What they mean is that in a quiet market period, when the fluctuations in stock, bond, or commodity prices are relatively small, trading opportunities are scant. In the extreme, if a stock stays perfectly steady, there’s no possibility of a trading profit.

Lately, with mounting concern about inflation creep, oil prices and Iran’s nuclear program, the market has begun to seesaw, allowing traders to step in as both buyers and sellers and causing volatility to rise. This variability is measured by the VIX index, developed in 1993 by the Chicago Board Options Exchange.

More specifically, the VIX is a realtime estimate of expected volatility. It is based on current prices being paid for S&P 500 Index options.That is, through mathematical analysis, the CBOE can extract from the prices being paid for puts and calls on the SPX the expected future volatility of the index.

Don’t get bogged down by the concept. Start with this: An option represents the right to purchase a given stock or other instrument at an agreed price at some point in the future. The price a buyer is willing to pay represents his expectation of whether that stock will go up or down over a certain time frame, as well as the buyer’s level of conviction.That level of certainty translates into his expectation about volatility. Mathematical models can figure that out.

Although somewhat esoteric in its derivation, this is not a game being played only by those personally armed with CRAY computers. The CBOE started trading options on the VIX in February of this year and already both retail and institutional buyers have piled in. In May, volume for VIX options totaled a record 1.02 million contracts – about equal to options traded on the Dow Jones Industrial Average or to the most actively traded stock option, which was Microsoft. That’s pretty impressive for a brand-new instrument. “I can’t recall a more successful new product,” the vice president for research and product development at the CBOE, Joe Levin, said.

The Chicago Futures Exchange, a subsidiary of the CBOE, was launched in 2004. It celebrated its biggest month in May, trading 56,925 contracts. The most actively traded item was the VIX future, accounting for 50,474 contracts. This is the turf of major institutions and trading houses such as Goldman Sachs, which is reportedly a major player.

So how does it work? Very simply, as the market gets whacked by surprises, either positive or negative, and begins to register big drops and gains, the VIX trades higher. Normally, the index trades in a range of about 10 on the low side to 25 or 30 on the upper end. In times of extreme upset, such as in 1998 in response to the Long Term Capital management crisis, the VIX has traded above 45.

Over the past year, the VIX has traded rather quietly, between 10 and 20. For the past few months, the index hovered in the low teens. In May, the still was shattered, and the index climbed to its current level of around 18 from 11.59 – a nice gain but still far short of the levels reached quite often over the past 10 years. For example, the high in 2002 was 45.08.

That suggests that as Fed guessing becomes more intense, and as concerns mount over growth, inflation, and other imponderables, the VIX has considerable upside. This is one reason that trading in the options and futures has picked up. Another is that trading the VIX is looked upon as a hedge. One reason that the “hedge” notion arises is that historically the index tends to move in the opposite direction to the underlying index.

We would caution that a portfolio that reflects optimism about the market cannot really be balanced or truly hedged byVIX calls. Rather, it appears to us to be a speculation that may well pay off. If all else fails, the VIX options may make you a profit. Mr. Levin puts it slightly differently, suggesting that trading VIX futures or options “could change the risk characteristics of your portfolio.”

Another interesting characteristic of the VIX is that it is quite volatile. Indeed, the volatility of the volatility (83% in 2005, for example) is substantially higher than of other indices such the SPX (10.3%) or the NASDAQ 100 (NDX) (13.9%). Which means, of course, that it is more fun to trade.

It is also an interesting trade in that often, and for most of this year, the trade was lopsided. That is, when the VIX was in the low teens, it was unlikely to go significantly lower. The market is always going to have some volatility. Thus, Group One’s Dominic Salvino, the specialist in VIX options, points out that traders were nearly all long the volatility index. While the options could blow out on the upside, the downside was reasonably protected. Mr. Salvino points out that now that the VIX has moved up significantly, the trading is much more two-way.

As usual, the potential attraction of a trade – in this case the VIX – is delightfully clear in retrospect. However, when we next enter a phase of relative complacency, it may be worth betting on anxiety.

peek10021@aol.com


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