How To Profit From Volatility

There is nothing certain in the stock market.  The bulls and bears are in a constant battle for dominance and the winner can change in a heartbeat.

However, there are a few things that are very likely to happen in the not so distant future.

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  • The first thing is that the Federal Reserve will start to increase interest rates.  The central bank’s multi-year accommodative economic policy of quantitative easing and ultra low interest rates has worked its magic.  The economy has been kick started back to growth.

    History makes it clear that the stock market performs best during times of low interest rates.

    Secondly, the European Central Bank is ramping up its monetary easing programs in an effort to jump start the floundering euro zone economies.   This means that European stocks will likely start to outperform which will divert U.S. investors away from the U.S. markets and into European stocks.

    Chief Economic advisor for Allianz and noted financial leader, Mohamed El -Erian explained to CNBC,

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  •  “Investors should expect a lot more volatility and they should expect more of what they saw in the first quarter, which is the beta trade in U.S. equities not going to be as satisfying as it has been in the past.”

     Thirdly, the spectre of higher interest rates will continue to strengthen the all ready soaring U.S. dollar.  This means that multi- national corporations and other businesses that suffer when the greenback is strong will continue to face this headwind.

    These items, when viewed together, create a very strong case that the stock market will start to move lower soon.   Remember, individual stocks will continue to outperform regardless of what happens to the overall market.  This is what El-Erian means when he says the beta trade will not be as satisfying as it has been in the past.  The beta trade means a bet on the entire market by going long an index rather than picking individual stocks.

    What Does All This Mean?

    A  dropping overall stock market means climbing volatility.  In the stock market, volatility is measured by the VIX index.  The VIX index will climb higher as the market drops lower.

    The Volatility Index or VIX was first designed in 1993.   Professor Robert Whaley is credited with creating the original idea.

    Since  options are priced based on the expected volatility or price changes over the next 30 days, the VIX reflects what option traders expect to happen in the next month.   Think of options as insurance, the greater the fear of something bad happening, the higher the price of the insurance, therefore the higher the VIX index.

    The above illustration from the clearly shows the negative fundamental event and what happened with the VIX reading during that time.   The sharper the selling or expected selling in the stock market, the higher the VIX moves.

    Breaking the VIX down to its formula, it is the square root of the par variance swap rate for the next 30 days.

    There is no need for an investor to get bogged down in the actual math.  The easiest way to think about the VIX is that it is the inverse of the S&P 500.  In other words, the VIX moves opposite of the S&P 500.

    The primary reason I like the VIX so much is that it is anticipatory. What this means is that the VIX often moves before the market does. This is because when professional traders strongly believe something negative is about to happen, they start buying options to insure against an adverse move.  This means, that sometimes, but observing the action of the VIX , you can foresee what will likely happen in the stock market.

    The VIX is resting near its 200 day simple moving average at 15.  Provided the fundamental backdrop, it appears very likely that volatility will increase.  In fact, it may increase dramatically over the next year.

     Here Are 4 Ways To Profit From Volatility

    1. Trade the VIX

    Since the VIX is an index, it cannot be traded directly.  However, options and futures are available on the VIX index.  One can sell VIX puts or buy VIX calls in anticipation of the VIX increasing.  Just like with stocks, a variety of straddle and strangle option strategies can be employed to capture the volatility of the volatility index.

    Looking at near the money October or November expirations is a suggested play on the VIX options.

    1. Own the Casino

    Donald Trump is famous for saying the only people who make money gambling are the casino owners. While this is a little bit of a stretch for option traders since for every loser there is a winner on the other side of the trade, the wisdom can still be applied to the financial markets.

    You can “own the casino” by purchasing shares in the Chicago Board of Options Exchange CBOE Holdings (NYSE:CBOE).  Owning this stock is a great alternative for investors who don’t want to get involved with options.  You see, as volatility increases, trading volumes in the options market increase, which in turn helps increase the profitability of the exchange.  Spiking options volumes means more commissions and fees to the CBOE.

    As you can see from the above chart of CBOE, price has fallen below the support level at the 200 day simple moving average.  The suggested play here is to place your buy order just above the 200 day sma to catch the break out when volatility increases…

    1. Volatility ETN’s

    As you know there is an ETF or ETN for almost any financial market you can imagine.  One of the most popular VIX ETN’s is iPath S&P 500 VIX ST Futures (NYSE:VXX) This ETN allows the stock trader to benefit directly from the VIX futures without the need of a futures trading account.

    As you can see from the chart, the VXX is trading near its recent lows.

    Using orders to catch a break out of volatility would be my suggested play on the VXX.  The reason being is that despite being convinced that volatility will increase soon, there’s no telling when exactly this will happen.  Waiting for the upward price momentum to begin to buy is the wise move with this ETN.


    1. Look Outside The USA

    The monetary easing in the euro zone should supercharge their stock market.  Just like what happened in the United States when the easing programs started, European stocks should follow suit.  Fortunately, you don’t have to open a special foreign trading account to access the European stock markets.  Just like with the VIX, there are a wide variety of broad market European ETF’s that can be easily traded in your brokerage account.

    My favorite euro zone ETF’s include SPDR STOXX Europe 50 ETF (NYSE:FEU) and Wisdom Tree Europe Dividend Growth Fund (NYSE:EUDG).

    The Key Takeaways

    The fundamental picture is pointing toward increasing volatility in the stock market.   An index known as the VIX tracks the changes in volatility.  Traders can take advantage of the likely volatility increase in many ways. Four of the most popular ways include trading options or futures directly on the VIX index, buying shares in the CBOE, using ETN’s and ETF’s to access the VIX with a stock trading account, and looking to the euro zone for investment opportunities.

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