Volatility scares investors, as it usually rises sharply when the stock market is falling.However, savvy investors and options traders love volatility as they can profit faster from the stock market’s random movement. There are many ways to profit from volatility, and pure stock investors might take the opportunity to buy undervalued stocks cheap when the market falls irrationally on news of global terror or other ‘bad’ news unrelated to their individual stock. Buying undervalued stocks cheap when the stock market drops is a very successful method espoused by none other than investing legend Warren Buffett, who said ‘Buy when everyone is selling and sell when everyone is buying’.While this is good advice, this requires a lot of capital, a long-term horizon, and the ability for the investor to analyze stocks to find the ones with ‘good fundamentals’ that they would be willing to hold for the long run.Options traders are more fortunate as they don’t need to have this unique analytic ability, nor do they need a long-term horizon to make money.

First, one needs to know what the VIX is, and how it is calculated. In brief, the VIX is the CBOE’s volatility index, and is derived from a range of strike prices of the S&P 500 index option chain.It is based on real-time option prices and changes during open market hours.

Second, one needs to know what a change in the VIX means to be able to profit from it.Since the VIX is derived from the prices of the S&P 500 index options, the VIX will rise if the options become more expensive, and fall if the options become cheap.Hedge fund managers and professional traders use the options on the major indices (like the S&P 500) to hedge their portfolios.Since option prices (like stock prices) are determined by supply and demand, when more numbers of options are bought, the prices of the options rise.Usually there is a sudden increase in demand when the stock market is falling, and professional traders scramble to buy put options for fear of a market crash.This surge of demand drives up the prices of the S&P 500 options, and in turn the VIX.Because of this relationship, the VIX is sometimes called the Fear Index.As the VIX can be plotted on a stock graph just like other stocks, options traders are able to monitor its movement and plan a trade accordingly.

HOW TO PROFIT FROM A VOLATILITY SPIKE – SELL VOLATILITY

In the stock trading world, a common adage is ‘Buy low, sell high’ – implying that one should buy a stock at a low price and sell it at a high price.For the options trader, the same adage can be said about volatility – ‘Buy low, sell high’ – that is ‘Buy when volatility is low, and sell when volatility is high’.The converse is also possible – ‘Sell when volatility is high, and buy when volatility is low (falls)’.To do this, one needs to monitor the VIX, and place a trade when it is either at historic lows or at historic highs. The rational being that, in time, the VIX will return to ‘normal’ – this concept (for math buffs) is termed as ‘reversion to the mean’.See graph of VIX below.

VIX in 2013

3 Month Candlestick graph of S&P 500

The first graph above displays the range of the VIX over the past year with superimposed Bollinger bands.The second graph is a candlestick price graph of the S&P 500 over the past 3 months with superimposed Bollinger bands. Bollinger bands are a technical indicator invested by John Bollinger to graphically display volatility of the movement of a stock or index being followed.The standard display shows a 20-day simple moving average with envelopes of 2-standard deviations around the average. The premise being followed is that whenever the price of the underlying goes beyond the envelopes, it will trend back to the average.One can see in the top graph whenever the VIX reached a high outside the envelope, within days it fell back into the envelope towards the average.

For the options trader who seeks to sell volatility, a potential trade might be a put credit spread – based on the premise that both the S&P 500 and VIX will revert back to the mean to garner a quick profit.Even with a plan for a credit spread, the prudent options trader will likely position his/her short strike far away from the current level of the underlying.In the example depicted in the graphic below the short strike on the SPX options is placed at a delta of 10, almost 150 points below the current level and way below the recent support.

SPX Put credit spread as a Volatility crush play

As noted in the daily report below the illustrative trade, in the days following, as the index rose, IV dropped and the trade became profitable.

Caveat Emptor! The above options trade is described purely to illustrate how savvy options traders may benefit from selling volatility spikes – it is not a trade recommendation. Readers are responsible for their own trades. An astute observer might note that sometimes the VIX rose only to rise again before dropping, and the S&P 500 dropped only to drop further before rising.  One needs to know and accept the risk in the trade, and to know how to respond if the S&P 500 drops towards the short strike.  But, that’s a discussion for another time …

Happy Trading!

If you currently trade volatility spikes –

Please share an example that illustrates how you made a quick profit.

If however you attempted to do so and were ‘burned’ – please share the lessons learned.