More Videos:

Taking Advantage of a 'Low' VIX

Tickers in this article: SPY VIX VXX


The relationship between realized volatility and implied volatility is always unique in that it never fully makes sense. Generally speaking we think of implied volatility as the dog and the tail as historical volatility. But, at times, the tail does wag the dog. I can think of numerous instances where implied volatility only moved after a stock or index started moving, like last week. What does the CBOE Volatility Index (VIX) point toward?

Clearly, a week ago Friday, the VIX was pointing toward a major move as it was breaking 22%. Thus, the forward-looking index correctly predicted that we would have a move that would produce back to back 2+ percent moves. Only a week after the VIX hit a 52-week high, the index is sitting at 52-week lows. When we come in today, the VIX will be trading right around 14%.

Yet the before and after can give us a very clear idea. If options traders were properly predicting a move of about 5% out of the cliff, and option traders were predicting the VIX to go back to 14% by Friday, what kind of realized volatility should we see over the 18 days that follow our cliff move? The answer is somewhere right around 12%...if the VIX is perfectly priced. If we accept that the VIX is almost always overpriced, especially when it is low, where does that put realized volatility for the next 16 days or so? Probably closer to 10%

This would still point toward an uptick from what we saw on Thursday and Friday where the market moved at less than 8% annualized volatility. Basically, the VIX may look like a buy at a 52-week low, but it's probably not (if you could buy it), the VX Jan future and certainly the iPath S&P 500 VIX ST Futures ETN (VXX) (which should almost never be purchased) look like terrible trades.

So how should traders take advantage of this "low VIX?" I would point toward a combination of buying and selling. I am willing to venture that there are some opportunities in March options that might be favorable to purchase right now. The March quarterly straddle in the SPX is probably a value at an IV of 13.8%. Even if we do not move that much, I think the decay will be slower than the model predicts as volatile creeps higher. That may be a nice trade.

I would also be looking for opportunities to sell volatility against that SPX straddle. Yen vol has ticked up considerably, maybe it is a sale. Maybe there are stocks out there when the premium is overpriced. Another trade might be to short VXX or VIX options against our SPX trade.

Usage of this site is governed by TheStreet's Terms of Use available here. Information collected on this site may be collected by TheStreet and OC Register. TheStreet's use of information collected on this site will be governed by TheStreet's privacy policy available here. OC Register's use of information collected on this site will be governed by OC Register's privacy policy available here. If either TheStreet's or OC Register's privacy policy have provisions that are more restrictive than the provisions of the other party's privacy policy, such more restrictive provisions shall not apply to such other party.

Copyright © 2012 Orange County Register Communications. All Rights Reserved.
Site Help | Site Map