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Stocks may be in more trouble than I thought.
As many of you may know, I expect to see an intermediate-term decline over the next several months.
The S&P 500 (NYSE: SPY) has pushed back to near multi-year highs. Simultaneously, the index has pushed into a “very overbought” state.
But more importantly, as I reported last week, one of the most reliable market indicators is signaling an imminent decline.
The indicator: The CBOE Market Volatility Index (^VIX).
The VIX serves as a "fear gauge" for the S&P 500. The index measures the prices investors are willing to pay for options that protect the value of their portfolio. The lower the VIX, the less investors will pay to insure their stocks – hence the less scared they feel.
When investors and traders become complacent, a market reversal is typically on the horizon. And I see no reason why this time should be different.
As the market has rallied, volatility has contracted to near-historic lows.
The VIX is down more than 50% over the past three months after trading around 28 when the S&P 500 bottomed in late May. Yesterday, it dropped below 14 for the first time since March 16.
And how did the market react the last time the VIX pushed below 14?
The answer lies in the chart below.
SPY tacked on an additional $1 before eventually faltering. In fact, over the next two months SPY lost $14, or roughly 10%.
This gives investors and traders alike a terrific opportunity to buy volatility before it surges higher again. The odds certainly favor a move higher from here.
On the downside, the VIX could fall to its historic low of 11 or so – a three-point drop from here.
On the other hand, a bullish move higher could realistically push the VIX all the way up to 25, a gain of nearly 80%. That may seem like an outlandish prediction. But keep in mind that when volatility expands, it happens fast. Just look at the move last March when the VIX nearly doubled in just eight weeks.
From an investing and trading perspective, this is an ideal spot at which to buy volatility. It gives self-directed investors and traders the chance to potentially make 11 points, while risking just 3. That's almost a 4-to-1 reward/risk scenario. More importantly, it's one of the best-looking trades in the market right now.
In fact, I recently bought a few calls on the VIX for my own personal account. As most of you know, credit spreads are my strategy of choice. But with volatility near historic lows, I prefer to take a more speculative approach by taking a small position size in the VIX.
If you have any questions on the VIX or options strategies in general, please do not hesitate to email me at [email protected].