Thursday, July 29, 2010
Get ready for more volatility.
On Wednesday, the volatility index (VIX) closed at 23, its lowest level since late April – right before the "flash crash" in early May. During the flash crash, the VIX spiked from 23 to above 40 in just a few hours.
The Volatility Index is commonly used as a measure of investor complacency or fear. A low VIX implies investors are relaxed and not concerned with potential turmoil in the markets. When the VIX is high, investors are panicking and running for cover.
The VIX also helps determine the premium option buyers pay to buy puts and calls. In periods of high volatility, and high levels of fear, investors are willing to pay more to reduce their risk by using options. Selling options when the VIX is high is a smart strategy and a great way to take advantage of fear in the marketplace.
But when the VIX is low, you need to be a buyer of options. And right now, options are as cheap as they've been in three months.
The iPath S&P 500 VIX Short-Term futures ETN (VXX) looks like it's ready to start a short-term up move. Take a look at this 30-minute chart...
This is a classic falling-wedge pattern. These charts usually break out to the upside.
Since VXX is designed to track the action in the volatility index, a breakout to the upside of this chart means volatility is moving higher. Of course, that means investor fear is about to increase – which is consistent with my belief that the stock market is ready to fall hard at least over the next few days. It also means the premium investors are willing to pay for options is about to increase.
If you ever wanted to buy cheap put options and bet on the market moving lower, now is a great time to do so. And if you're interested in income-producing strategies like selling covered calls or selling uncovered puts, you'll have a terrific opportunity to make money once this pattern plays out and the VIX blasts higher.
Best regards and good trading,
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