So far 2012 has resulted in a melt up higher in the major market indexes and a decline in volatility as measured by the VIX. We’re a little hesitant to jump into the market here given its 20% increase since October 4th. At the same time, we’re also not confident in positioning for a spike in volatility due to how calm things have been over the last 5 weeks. Therefore, we’re going to implement an options strategy that would perform well if volatility rises or if the S&P500 extends above 1,300.
Before we reveal our strategy we will put forth this thesis: An inverse correlation between the S&P500 and the VIX has been in place for at least the last 36 months – when the S&P500 rises, volatility (VIX) falls; when volatility (VIX) rises, the S&P500 falls. With that in mind, we are going to buy the VIX 20 puts expiring February 14th for $0.60 (costing us a mere $60 per contract) as well as SPY 127 puts expiring January 20th for $0.56 (costing us $56 per contract). Our break even on both short positions will be 19.40 (7.8% below current price) on the VIX and $126.44 on SPY (2.1% below current price).
There are multiple reasons we like this trade. For starters, it’s a very cheap trade to put on, the most we can lose in either case is $0.60 and $0.50. Furthermore, we are essentially betting that the S&P500 isn’t going to remain completely flat over the next 7 trading days. We say that because that is the only way both of these premiums will go down.
Think about it, based on our thesis if the SPX rises then the VIX is going to fall. That will cause our SPY premiums to decline but it will cause our VIX premiums to increase, possibly dramatically so. Vise versa, if SPX rises and the VIX spikes dramatically causing our premiums there to decline, our SPY puts should rise sharply since we’re only a little more than week away from expiration. If SPX stays flat then we assume the VIX will stay flat as well, so both premiums would erode but such an occurrence is unlikely in our opinion.
With Spain and Italy doing their first debt sales of the new year Thursday Europe is bound to provide some market moving news. We’re in store for the regular update on weekly jobless claims. In addition, Friday will bring Thomson Reuters/University of Michigan consumer sentiment index. Then you must consider the technicals as well. We’re at the top of the recent range and on the verge of a major breakout or a major short signal being given. For all of these reasons we feel our strategy is a perfect way to bet on a rebound in volatility, or a further decline.
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