Short Term Trade: When the VIX spikes and then closes below the previous day level the next day, it leads to a period of positive returns for equities.
How do I hedge and why did my hedge not work in the past? Most people look at options, particularly PUT options as a stock insurance policy.
What was once a slow grind down in terms of market volatility — and perceived risk — is now a slow grind back higher.
The dollar keeps grinding to lows we have not seen before, but strangely enough, volatility is dropping as well.
Two big uncertainties have come out of the market. Firstly, election expectations have been realized and so far the market likes what it sees.
Protecting yourself from QE2 and next week
As the global market continues to push higher, some large-cap names are becoming interesting ideas for traders looking to add options to a standard long-only portfolio.
Looking at the VIX, we are seeing continued pressure on volatility as this volatility-driven index seems to have found a range between 20 and 25 — well off the nosebleed-inducing 45 it touched during the May euro crisis
The 200-day moving average currently 23.5 and is trending sideways, which according to the Stutland Volatility Group bodes well for a market that could hold this range and continue its current uptrend.
This, in turn, makes stocks like Caterpillar (CAT, quote) interesting, Stutland analysts say.
Caterpillar: in position
Given bullish momentum for the S&P 500 (SPY, quote) as a whole, this a solid industrial stock that appears to be well positioned for further upside — and more than half of its revenue already comes from overseas, so it is highly leveraged to emerging markets growth.
The stock is currently trading at around $78.15. If you think the stock can move higher, you can buy 100 shares at $78.15 and also sell the January $85 option (currently priced at $2.38) that obligates you to sell 100 shares at $85 in January.
If you buy 100 shares at $78.15 apiece and sell 1 January 85 call for $2.38 you can potentially realize a gain of 11.8%. Writing the January 85 call allows you to collect 3% premium on the stock. If the stock trades between 78.15 and 85 at January expiration you will collect the 3% premium on the option write, plus the accumulated value of the stock. Your breakeven on the spread is 82.62.
If CAT rises, but remains below $85, your option entitles you to sell your shares that above-market price, netting a return of 8.7%. Add the $2.38 a share you got for your option, and your total return could come to 11.8%.
If CAT rises above $48, you forfeit the extra appreciation, so your total return is capped at “only” 8.7%. However, the covered call should add to your performance as long as CAT stays under $82.62.
And if CAT declines, the $2.38 a share you got in cash when you wrote your sell option helps to minimize the downside.
Market volatility has pulled back a lot since the spikes of May, but while it can be a relief to get out from under the cloud of fear, it is always possible (and often expensive) to get too comfortable.
Watch the VIX. We have seen real market reaction at around 23, which you could look at as the current “complacency” trigger. The last time the VIX dropped below that level was June 21, when Europe looked like it was under control again, China looked good and everyone seemed content with U.S. data … and the market fell about 10% over the next 10 sessions.
We are currently at around 24.30. In a day or two, we could be back in complacent territory, so it is time to get a little nervous and hedge your book.
You can short the U.S. market via tactical exposure to various “inverse” ETFs like SDS.
If we get a fresh round of selling on Wall Street, it will almost certainly spill over into foreign markets. Remember May, when the fear fed on itself and chased money out of Europe, Asia, Australia, commodities, currencies and everything else short of gold, the dollar and Treasury debt?
There are even a few country-specific short ETFs out there now. China is probably the biggest niche here; while there are double- and even triple-short China funds, YXI is probably plenty of downside protection.
Inverse ETFs work by shorting the underlying index. Thus, you should expect YXI to deliver the opposite returns of a long-only fund like FXI:
Both the VIX and five-year Treasury prices are sharply lower this afternoon, which suggests that the dread out there may be easing after the recent sell-off.
The VIX, the more popular “fear indicator” in the media, is down 8% today and has plunged about 30% over the last week. That could be a sign that most of the selling pressure has crested, at least for the short term.
Likewise, five-year Treasury prices — a less-famous but equally crucial risk indicator — are plunging as the risk trade evaporates, pushing yields up a full percentage point.
This is not necessarily a buy signal, but it gives us all a chance to catch our breath as we go into summer. Markets could well drift lower after the bounce.