Using the VIX to Find High Probability Trades

In my last article I talked about TradingMarkets mantra of buying weakness. I covered how we look for market moves that move too far, too fast, where we look to take advantage of the mean-reverting snap-back rally. I talked about how we use several indicators such as the RSI, DMI etc., to define the ‘mean’ and how we use statistics to define high probability areas for buying weakness.

One of the key indicators that we use to define high probability buy areas is the VIX. With the extreme sell-off that we saw on Tuesday, I want to cover how I used the VIX to place high probability trades. If we look at the VIX chart (below) and we look at area 1 we see a very low VIX reading that indicates extreme complacency on the part of the market participants. The low VIX readings, around the low 10 level, shows that investment managers, hedge fund managers and investors are not interested in buying portfolio “insurance” in the form of put options because they feel that the market is going up. Also, speculators who place their bearish market bets through buying put options are absent because they too are looking for a market that is going to go up.

VIX

If we reflect on the events of the past few weeks, one theme that kept playing over and over again in the financial media was the fact that this is a “Goldilocks economy,” that Bernanke got it right, that he engineered the perfect economy etc., etc. The talking heads on a popular TV channel were so jubilant because of the economic data that was coming out suggested an economy that was not too hot, and not too cold, that they were like high school cheerleaders cheering for their favorite quarterback. So what does this mean to us as traders?

The classic Wall Street adage is that when everyone is extremely bullish, where they are voicing how the economy or the market couldn’t get better, then this means that everyone who is bullish has already bought stocks. If everyone has bought, who is left to buy to push the market higher? So when the talking heads keep blaming the extreme sell off on Tuesday on this or that, the reason beneath all of the superficial comments is that everyone was bullish and had already bought. This is reflected for us in the very low VIX reading. So how do we make money trading the VIX? Going back to the VIX chart we see at bar 2 the extreme expansion in the VIX from the low 10 area to an extreme reading above 18. This, of course, coincides with bar 2 on the SPY chart (below). What does it mean when the VIX has such a huge spike up? This means that as everyone was heading for the exits in the stock market, they were also clamoring to buy put options for both protection and speculation. The huge demand for put options drives up Implied Volatility, which is reflected in the high VIX reading. The VIX is often times referred to as the “fear index” because it is measuring the amount of fear of the market participants through their purchase, or lack of purchase, of put options.

SPY

So, how do we take advantage of this and make money trading it? On Tuesday (Bar 2 on the SPY chart), the TradingMarkets S&P Market Timing Course generated buy signals. I like to buy deep in-the-money call options when I get buy signals because it limits my risk (I risk only the amount paid for the call option) and I tie up less money (I can control 1000 shares of the SPY with approximately $10,000 as opposed to $140,000 with buying the SPY ETF). Buying deep in-the-money calls on Tuesday seemed to be a great strategy because the extreme nature of the sell off made me want to reduce my risk exposure in the market. I went to buy the SPY call options near the close to take advantage of our numerous buy signals that had triggered and noticed that the Implied Volatility had shot through the roof, causing the prices of the call options to also become very expensive. As implied Volatility expands, the extrinsic value or time premium that you pay for options also greatly expands.

Options that are very expensive greatly reduce our probabilities for a successful trade. How do we increase our odds of a successful trade when volatility expands and causes option premiums to become very expensive? When Implied Volatility expands we want to be sellers of volatility or options and when Implied Volatility contracts we look to be buyers of volatility or options. As several buy signals triggered on Tuesday I was looking for a way to take advantage of the buy signals (go long) but also reduce my risk exposure. Since the call options were very expensive I looked to selling the expensive put options, or selling volatility, as a way to entering the trade.

How do we do this? When we get our buy signals and option premiums are expensive, we will look to selling puts naked or putting on a bull put spread. Let's go through the process of selling puts naked -- on Tuesday the SPY closed at 139.50. We would look to sell the front month 139 put naked capturing the premium. We would profit as three aspects of options work in our favor as the market has a mean reverting bounce:

1. As the market moves up, the price of the put option we sold will go down.
   
2. As the market moves up after a sell off Implied Volatility will contract causing option prices to fall.
   
3. We benefit by Theta or the time decay of selling an option since all options are wasting assets.

Selling naked puts does expose us to a lot of risk and the way the market traded on Tuesday made me want to greatly reduce my risk. When option premiums are expensive and I want to reduce my risk, I look to put on a bull put spread.

In this strategy we sell the at-the-money put (in this example we sell the 139 or 140 put, since the SPY closed at 139.50) and we simultaneously buy a lower strike put to limit our risk. So in this example we are selling the front month 139 put, taking in 2.10 as a credit, and simultaneously purchasing the front month 134 put option for .70. We take in a total premium of $1.40 per bull put spread and reduce our risk exposure to a total of $3.60 if the SPY moves below 134. Here is a great way to use the VIX in choosing what financial vehicle to use to take advantage of buy signals that trigger to put the odds of a successful trade in your favor.

Learn more strategies like this in the "TradingMarkets S&P Market Timing Course". To listen to a free Market Timing presentation led by Paul Sabo and Larry Connors, click here.

Paul Sabo has been a professional trader for over 18 years. During this time he has worked as a market maker in both New York City and San Francisco for some of Wall Street's most prestigious investment banks, commercial banks and brokerage houses. Paul later became the head trader for a top-ranked investment advisor and hedge fund based in San Francisco. Paul recently left his position at the hedge fund to trade his own money as a full time business as well as working with Connors Research Group on various proprietary projects.