What to Do if Volatility Returns This Fall

With the last long summer weekend now in the rearview mirror, I’m sure plenty of investors are starting to focus on a whole new array of worries out on the horizon — including a contentious presidential election as well as the prospect of rising interest rates.

But rather than succumbing to those fears ourselves, I think it’s far better to learn how to use them for profits!

The first step, of course, is having a reliable way to measure the general level of fear in the market at any given time.

Enter the “VIX” … a market index that “mom and pop” investors rarely look at.

Officially known as the CBOE Volatility Index, and unofficially as the “fear index,” this gauge shows you how aggressively options investors are betting on the stock market’s future moves.

More specifically, it indicates how much volatility they expect in stocks over the next month.

I could go even further into the explanation, but the math is both complicated and extremely boring.

So, suffice it to say that whenever the VIX is rising, investors are collectively growing more worried. When it’s falling, they are feeling more complacent.

And right now, investors are about as relaxed as they’ve been all year.

Most people accept a level of 20 or more as market panic, but as you can see, the VIX is currently sitting around the 14 level …

So Investors Are Feeling Pretty Calm Right Now,

But That Might Change As We Move Deeper into Fall …

Obviously, investor sentiment can switch on a dime … and I’ve already cited a few reasons that could cause just such a turn.

So while we never know exactly how things will play out, it is reasonable to think that the VIX will go higher from current levels at some point over the next few months.

That brings me to a few specific ways to use the VIX to make money …

Because of various exchange-traded funds and notes, it is now quite easy to bet on the VIX itself.

For example, if you believe investors will actually get even more complacent, you can buy the VelocityShares Daily Inverse VIX ETN (XIV). It’s designed to rise twice as fast as the VIX drops.

On the other hand, if you believe the VIX is far more likely to spike, you can use the iPath S&P 500 VIX Futures ETN (VXX).

Of course, I want to emphasize the fact that both of these investment vehicles are for VERY short-term speculations and should only be used if you’re a savvy trader that understands the inherent risks associated with the way these exchange-traded notes are constructed.

So another interesting correlation that you can use is the VIX’s relationship to gold prices.

Historically speaking, the VIX and gold prices have often risen in lockstep. This makes sense since gold is widely viewed as a crisis hedge — precisely the thing that investors seek out when they’re worried.

Therefore, if you expect the VIX to rise, you could also consider going long gold through a paper proxy like the SPDR Gold Trust (GLD) ETF.

Of course, my favorite way to take advantage of a rising VIX and growing investor fear is by selling options to other people.

The reason is simple: When the market is panicked, investors are desperately buying options contracts to hedge their portfolios against big price movements.

As with any other marketplace, prices for these options contracts rise along with the demand.

Therefore, selling options at such times allows you to collect bigger cash payments into your portfolio.

Remember, as an option SELLER, you are on the other side of the trades made by those panicked investors.

You are essentially selling insurance to them. And in exchange, they pay you premiums upfront.

The more panicked they become — which you can keep track of through the VIX — the larger the premiums you can ask for.

It’s also important to remember that only 10% of options ever actually get used. That’s straight from the official authority on option contracts, the Chicago Board Options Exchange.

So whenever you sell an option that ends up expiring without being exercised, which happens 9 out of 10 times on average, you are basically walking away with free money!

The main point? Even though it might seem backwards to want to sell insurance when the market is panicked … that’s exactly when you SHOULD be doing it.

Best wishes,

Nilus