Fast and Furious Volatility is Back in a Big Way
The Smart Profits Report: Issue #321
Thursday, June 22, 2006
Fast and Furious Volatility is Back in a Big Way: How To Profit Using Leg Spreads & The VIX
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Fast and furious volatility is back in a big way.
Over the past few weeks, I’ve written about how volatility is barreling back into the market with a vengeance. But the level and rate at which it’s jumped in such a short amount of time is remarkable - the ultimate definition of “fast and furious.”
So why is this happening?
There are many reasons, including the obvious ones like rising inflation and higher interest rates, America’s bloated deficits, military conflict and geopolitical strife in the Middle East.
But there’s a bigger force at work here…
- Many investors became very complacent.
- They believed the markets wouldn’t go down…
- That commodities are king…
- And that the empire was fully-clothed.
You and I both know that, yes, the markets will eventually trend upwards again…that commodities might well be king…and that the empire will hopefully regain a full wardrobe. But beware: This is a longer-term picture. In the short-term, it’s that complacency that has led to higher volatility and made some investors pay.
How We Cashed in on Volatility for 50% Profits
However, no matter what the event is, or how serious it is, there’s usually a way to profit from it. And that’s exactly what the subscribers in one of my services (The LEAPS Trader) did recently.
In anticipation of higher volatility, I advised them to take a position that went LONG on volatility, using the VIX Volatility Index, which basically measures implied volatility over the coming months. The options are as easily tradeable as any other option in the market and the recommendation said to buy February 2007 options.
Having entered the trade when the VIX was hovering around 13, it hit 22 within a few weeks. That was a day many investors probably felt like turning off their computers and packing up for the day. But LEAPS Traders cashed out - and pocketed 50% gains, just as the markets were down a full 10% across the board from their highs. Much better than the ugly 30% slump in emerging markets, but down nonetheless.
That’s iron-clad proof that even when volatility is rampant and the markets are stumbling, it’s still possible to grab excellent profits.
The End of Volatility and Profits? No Way! “Legged Spread” Leads to More Gains
Many investors would be delighted with 50% gains - and rightly so. But whenever there’s an opportunity to make more, we’ll grab it with both hands.
Realizing that the spate of volatility was far from over, LEAPS Traders then made that 50% seem tame by engaging in a “legged spread.” This is my favorite type of trade, because it accomplishes what every investor dreams off: No downside and huge upside.
At the time of the trade, the initial options that my traders bought for $2.70 was bidding for $4.20. Those who wanted to sell did so - and enjoyed the 55.5% gains.
I advised those who wanted to stay in to hold on to their existing options and sell some others against the position they held. Why? Because when I checked the prices of the options that were one strike higher, I noticed that the bid was $3.
How The Legged Spread Leads To “Option Envy”
We bought the original options, a $15 strike price for $2.70. Against this position, we sold the $17.50 strike options, worth $3. When you sell an option for more than the one that you are holding is worth, you end up in a position known as “options envy.”
Net result? Those investors were being paid $0.30 cents per contract to hold this position (the difference between $2.70 and $3).
Here’s the kicker: Ultimately, this trade cannot lose. The least amount of profit available is $0.30 per contract. And the upside potential? The price of the spread - $2.50 (the difference between the original $15 strike price and $17.50 strike price that you’re selling against the first option).
Since it’s complicated to calculate a return on a trade where your basis is negative, let’s use a nickel as our bet. Assuming you buy ten contracts, the cost of your spread would be $50.
Here’s the upside: If the VIX, closes at $17.50 or higher at expiration, each ten-contract spread would be worth $2,500. So if you risked $500 initially, then your upside would be $25,000. Worst-case risk scenario? You “only” make $0.30 per contract.
Market Moving Against You? Use the VIX
Investors ask the question all the time: I can make money when the market is trending up - but how do I protect my investments when it moves against me?
That’s where the VIX can be your best friend. When the market is moving against you, it’s made for a trade like the VIX spread illustrated above.
Remember…the options market was created by professionals to hedge positions against risk. You’re just exploiting their secrets and using them to protect yourself from the inherent risks of investing in today’s unpredictable markets. It’s just about as ideal a solution you’ll find.
And what’s almost as good as making money on the VIX? Making money on the QQQQs…if you are short that is. More on that next time.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- You’ve seen how my LEAPS Trader subscribers pocketed 50% gains and more, simply by using what the market gave them - volatility - to profitable advantage. Find out how you can join them and make money like that for yourself. Call our VIP Trading Services team at: 1-888-570-9830
- Several key options terms for you to learn in today’s message. Use our Smart Profits Glossary to find out the meaning of phrases like: LEAPS, Volatility, VIX, and Spread.
Related Articles:
- The VIX Index: Instant Access to the World’s “Best Contrarian Indicator”
- Market Volatility: How to Pay $27 for a $50 Stock
- LEAPS vs. Stocks: How to “Own” Almost Any Stock for Pennies on the Dollar
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