How to Take Advantage of a Bull Market in Volatility

VIX hit 46, you buying anything?

That was what one of my brokers e-mailed on September 29th.

The “VIX” is the nickname for the CBOE Volatility Index. It’s often called the Fear Index. In the past, it has been a good indicator of when fear has peaked.

The VIX tracks the amount of premium someone is willing to pay for S&P 500 option contracts. It is a basically a measure what it costs to insure against a market collapse. It’s basically the cost of portfolio insurance.

When the index hit the mid-40’s in 2003, it was the bottom. When it surged to the mid-50’s (the previous all-time high) in 1998 when Russia defaulted on its debt, it was a fantastic time to buy. So this time, when it hitting new 5-year highs in late September, a lot of hopeful people were expecting a bottom.

Those who did probably didn’t fare too well. Since it hit 46 in late September, the Dow has fallen more than 2000 points, an additional $2 trillion dollars of wealth was wiped away, and a lot of stocks have fallen even more.

My response to the email was: “No way…VIX at 45 means you should be writing options…THAT IS ALL.”

Fear might have reached its previous highs, but this time it really is different. As you’ll soon see, there are some truly astounding opportunities created. Arbitrarily buying stocks is not one of them.

We’re entering a bull market in volatility. And there’s one investment that any investor can make that actually does better the higher volatility is. It allows you to be perfectly positioned for whether the market rebounds, stays flat, or continues to fall.

You see, when the VIX soars, you capitalize on the volatility by writing options. Think about it for a second. Options are kind of like insurance and the VIX is an indicator of how much other investors are willing to pay for insurance. If you’re looking to buy low and sell high, the VIX is what you want to sell.

The easiest way to do that is write option contracts.

Now I realize most of us don’t have accounts where we can write options. After all, writing volatile options subjects you to unlimited risk. But there is a way you ghost-write options and capitalize on the volatility.

For instance, if you write someone a put option on General Electric (GE) and GE shares fall, they have the option to sell them to you at the predetermined price. If the price you agreed to buy them at is $25 and GE falls to $15, you’re out the $10 per share.

Of course, you do get compensated for writing the option. In this case, you’d probably be paid $1 per share for that right. That $1 will offset part of the loss, but nowhere close to all of it.

There’s a way to reduce all that risk though. It’s call covered call writing. For example, you would buy 100 shares of GE and write a call option against it. If shares of GE are trading at $20 per share you can buy 100 for $2000.

Then you can sell (or write, same action different terminology) a call option against those shares with a strike price of $25. That would give someone else the right to buy the GE shares from you at $25. You would probably earn about $100 for selling the option.

So, you have 100 shares of GE and $100 cash and someone has the option to buy them from you at $25. If GE shares stay in between $20 and $25 they will never exercise the option and you get to keep any profit on your GE shares. If the shares rise above $25, the holder of the option will exercise their right to buy those shares at $25.

If they fall, you get the keep the extra $100 paid for the option to offset your losses.

Covered call writing is simple, but it’s not for everyone. It can be complicated, there are some risks, you’ll realize no tax benefits due to the in and out nature of the strategy and there you’ll probably pay some pretty high commissions active trading.

That’s why there is an ETF that works just like a covered call. The iPath CBOE S&P 500 Buy-Write ETF (BWV) cuts out all of the commissions, tax consequences, and other drawbacks to the covered call writing strategy.

Remember, volatility is high and it isn’t going away. There are no fundamentals to drive the market significantly and sustainably higher. Markets rise when confidence is growing and right now confidence has been shattered. The long-term creator of confidence is the economy. And with unemployment on the rise, it’s going to take a while for the economy to get turned around and spark some confidence back in the markets.

As a result, there will be rallies, significant sell-offs, and plenty of up and down weeks that take the major indices nowhere. But volatility will be high and the cost of insurance will remain high. Now is a great time to be providing that insurance and covered call writing is a relatively safe way to do it. Finding an ETF that does the same strategy is a way to ghost write options and not have to deal with all the hassle.

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