What a difference a few days make. On Dec. 12, the S&P 500 Volatility Index (VIX) had just risen about 80% in a short span while the underlying S&P 500 itself was down around 3%. The differential between a move in the broad market and in the VIX is typically only around 8 to 1, and yet we were staring right then at a bizarre moment in time when institutional investors had literally bought 20x more insurance against a market decline than they really needed.
There are very few corners of the market where you can see well-intentioned, smart managers act against their own economic interest in such a persistent fashion. Normally, such large anomalies are arbitraged away by the market very quickly. Yet this aberration persists week after week. I suppose we should not call it to their attention, because it sure works for opportunistic traders like me and my subscribers.
You would think that ultimately fund managers would get a clue and realize that their extreme swings of panic — reaching to buy puts on the S&P 500 in such vast quantities and at light speed every time the tape turns red for a few days — are costing their own customers billions of dollars every month in what amounts to unneeded insurance premiums. But they keep doing it; go figure.
The interesting thing about the most recent bout of panic at the Wall Street disco is that the ratio seems to have reasserted itself: The S&P 500 is up 3% and the VIX is down 20%, which is around a 7:1 ratio.
Since the relationship got so out of whack before, it would make sense for the ratio to get extended in the opposite direction this week; now that December options expiration has completed, I expect cooler heads to prevail. You may have noticed that the iPath S&P 500 VIX Short Term Futures TM ETN (
VXX) has not yet collapsed the way it would seem that it should — considering the decline of the underlying VIX — but it most likely will before too much longer. When it does, you will be well-positioned to profit via the following trade in VXX puts.
Buy the VXX Jan. 17th $28 puts at current prices (around $1.50) for target $2.15. The option’s ticker is VXX150117P00028000; note that it is the January monthly option expiring on Saturday, Jan. 17, although some brokers may list the expiration as Friday, Jan. 16.
Jon Markman operates the investment firm . He also offers a daily trading advisory service, , and , a service that helps individual traders make steady, consistent profits with volatility-related instruments.
