How to Ride an Aging Bull (Guest Columnist at Barron’s)

Yesterday marked the fifteenth time I have served as a guest columnist for The Striking Price at Barron’s and How to Ride an Aging Bull is one of the few articles I have written for Barron’s that has not focused almost exclusively on the VIX and volatility.

In the Barron’s article I note that pundits have been calling this “the most hated bull market ever” for about three years and partly as a result of the mistrust of large bull moves, many retail investors have exited the market when they feared prices were getting ahead of themselves. As stocks have continued to rally, these same investors have had difficulty getting back in at even higher prices. Now, with 2015 just around the corner, quite a few of these investors believe stocks can continue to move higher and are wondering how they might be able to take advantage of a continued rally even though they believe the six-year bull is too long in the tooth.

An approach I discuss in the Barron’s article is one of seeking out value in underperforming sectors. In the article I cited the energy sector as the headline underperformer, but noted that while the energy sector ETP (XLE) is down 8.5% year-to-date, the metals and mining sector ETP (XME) is down 18.7% for the year. [Unfortunately, due to an editing snafu, the updated numbers I provided using data following the OPEC meeting were not incorporated into the publication.]

The XME March 33/38 risk reversal trade (short the March 33 put; long the March 38 call) cited in the Barron’s article uses strikes and prices that are quite stale now that OPEC has decided not to cut production. An updated version of the trade that would still generate a small credit would use the March 32 and 37 strikes, with a profit and loss chart that looks like the one below. Note that if XME is between 32 and 37 at expiration, the trade will generate a small profit. Should XME settle below 32 at expiration, the risk reversal (blue line) would lose about 2.24 less than holding the underlying (dotted gray line); if XME settles above 37 at expiration, the risk reversal gains would be about 2.76 less than if one had held the underlying.

[source(s): VIXandMore]

While metals and mining have had a difficult year, the recent rate cut by the People’s Bank of China and the anticipated near-term stimulus measures from the European Central Bank should provide a lift to metals and mining stocks. Other factors, including continued strong U.S. economic growth, could also bolster XME, which focuses mainly on steel, coal and aluminum for the U.S. market.

As noted in the Barron’s article, one could also make a similar trade with one of XME’s most liquid components, Alcoa (AA), where a short February 16/19 risk reversal has a similar profit and loss potential, yet taps into one of the metals and mining sectors, aluminum, that has been a very strong performer in 2014. As Alcoa’s options market is more liquid than that of XME, the single-stock version of this risk reversal should be considered as an alternative way of achieving similar exposure.

Related posts:

• A VIX Risk Reversal
• Agricultural Commodities vs. Base Metals
• Breaking Out Recent Commodities Moves
• Energy Sector Weekly Chart and Support Levels
• Sector Performance in the Last Two Bull Moves
• The Energy and Materials Rally
• Technology, Energy and Bulls

A full list of my Barron’s contributions:

• How to Ride an Aging Bull (November 29, 2014)
• Investors' Best Options in a ‘No Fear’ Market (July 2, 2014)
• Low Volatility: How to Profit from a Quiet VIX (May 22, 2014)
• Emerging Market Stocks: Have They Hit Bottom? (March 28, 2014)
• How to Spot Risk Early (July 16, 2013)
• How to Insure Your Stock Portfolio (April 18, 2013)
• The Case for Options Trading (January 2, 2013)
• Calm Down and Exploit Others’ Anxieties (November 14, 2012)
• How to Trade Options Around Volatile Events (July 10, 2012)
• Be Greedy While Others Are Fearful (May 3, 2012)
• Ways to Turn Volatility into an Asset Class (January 12, 2011)
• There’s Opportunity in Uncertainty (November 18, 2010)
• Will Market Volatility Return to Crisis Levels? (September 15, 2010)
• The Perils of Predicting Volatility (May 20, 2010)
• Take a Longer View on Volatility (July 2, 2009)

Disclosure(s): none

Low Volatility: How To Profit From a Quiet VIX (Guest Columnist at Barron’s)

Today I was once again a guest columnist at Barron’s, penning Low Volatility: How to Profit From a Quiet VIX for the venerable Barron’s options column, The Striking Price.  While this is my thirteenth turn as guest columnist, much to my surprise this is the firsts time that “VIX” has appeared in the title.  Since everyone seems to be talking about how low the VIX is, whether the VIX is broken, etc. I thought it would be an appropriate time to share some of my thoughts on the subject.

In the Barron’s article I make the point that while mean-reversion trades when the VIX spikes higher has been a viable strategy over the years, the mean reversion approach has not fared nearly as well when the VIX dives substantially below its long-term mean, which happens to be just a shade over 20.

As the chart below (monthly bars of the VIX) shows, most significant VIX spikes tend to be short-lived, but the VIX can remain well below the 20 level for multiple years in a row. Just look at 1994 – 1996 and 2004 – 2007 and think about the long-term viability of buying VIX calls or putting on a similar long volatility position during a period like this one, armed with the knowledge that eventually the VIX will have to revert to its historical mean.

[source(s): StockCharts.com]

In fact, there have already been two instances (1990 – 1994 and 2002 -2007) in which the VIX declined steadily for a period of at least four years. With the most recent peak volatility in August 2011, it is not unreasonable to think about the possibility of volatility continuing to decline or at least tread water through at least August 2015.

While the Barron’s article does not give my options trade idea a label, it is a ratio risk reversal that contemplates selling VIX June 14 puts and (perhaps) investing the proceeds in twice as many VIX June 17 calls.

I encourage everyone to read the original article at Barron’s, but for those who might not click through, I will include my closing paragraph below:

“No matter what your market outlook, however, do not make the mistake of thinking that the VIX is no longer relevant, and be careful when it comes to equating a low VIX with complacency. The VIX has closed below 13 some 964 times – and almost all of these instances have been in the middle of a bull market.”

Related posts:

• Was the VIX too Low in 2013? No…
• A VIX Risk Reversal
• Why VIX Puts Get Cheaper in More Distant Months
• Selling VIX Puts with the Help of a VIX Put Matrix
• Anchoring and a VIX of 20
• VIX Macro Cycles
• Was 2007 the Beginning of a New Era in Volatility?
• Shrinking VIX Macro Cycles
• VIX High or Low? It Depends…

A full list of my Barron’s contributions:

• Low Volatility: How to Profit from a Quiet VIX (May 22, 2014)
• Emerging Market Stocks: Have They Hit Bottom? (March 28, 2014)
• How to Spot Risk Early (July 16, 2013)
• How to Insure Your Stock Portfolio (April 18, 2013)
• The Case for Options Trading (January 2, 2013)
• Calm Down and Exploit Others’ Anxieties (November 14, 2012)
• How to Trade Options Around Volatile Events (July 10, 2012)
• Be Greedy While Others Are Fearful (May 3, 2012)
• Ways to Turn Volatility into an Asset Class (January 12, 2011)
• There’s Opportunity in Uncertainty (November 18, 2010)
• Will Market Volatility Return to Crisis Levels? (September 15, 2010)
• The Perils of Predicting Volatility (May 20, 2010)
• Take a Longer View on Volatility (July 2, 2009)

Disclosure(s): none

A VIX Risk Reversal

With the VIX at about 14.50 as I type this and a large group of investors convinced that stocks are overbought and/or not properly discounting global macro risk, many are wondering just how to translate their beliefs into an effective trading strategy.

For those who think a long volatility trade is the answer, there is the issue of the significant contango headwinds, where a negative roll yield will pummel net asset values on VIX options and VIX exchange-traded products as a part of the daily rebalancing process, while VIX futures are subjected to a similar decay that reminds me a little bit of a dying helium balloon. Long story short: there is a huge daily penalty being assessed just for holding these long positions.

There are ways to minimize the effect of negative roll yield and typically one of the best of these is to work with positions that focus on the more distant months of the VIX futures term structure. This is generally why VXZ outperforms VXX over an extended period. Unfortunately for aficionados of VXZ, the negative roll yield between the fourth and seventh month VIX futures (VXZ buys the seventh month and sells the front month each day) hit a new record on Monday and continues at near record levels.

So what is a long volatility trader to do?

One trade that I somehow have never managed to highlight in my 5 ½ of writing about the VIX is a VIX risk reversal. A risk reversal is essentially a synthetic long position in which a trader uses options to create a position that is similar to owning the underlying, but typically ties up less capital in the process. In the case of a risk reversal, this means selling out-of-the-money puts and buying out-of-the-money calls. In many instances, the sale of the put options will finance 100% of the cost of the calls.

While the VIX is currently trading at 14.50, keep in mind that the best proxy for the price of the underlying for VIX options is the VIX futures for the corresponding month. So, with the September VIX futures at 18.95 at the moment, one could sell the September 18.00 puts for 1.50 and buy the September 24 calls for 1.05, pocketing the 0.45 differential. A more conservative trader might look to sell the VIX September 16 puts for 0.55 and use the proceeds to pick up a September 30 call for 0.55 or to defray some of the costs of the purchase of a more expensive call, such as the September 24 (priced at 1.05) mentioned above.

There are ways to turn this idea into a more aggressive trade as well. One approach is to morph a risk reversal into a leveraged trade in which more calls units are purchased than put units are sold. An example of this approach might involve selling the September 19 puts (which are currently at-the-money) for 2.15 and using the proceeds to purchase two contracts of the September 24 calls for 1.05 each.

A risk reversal also goes by other names, notably a long combination (or long combo) and, despite the name, is a high-risk trade that is vulnerable to the ravages of time decay. This trade is not for everyone, but can be a good way to generate significant long exposure with a minimal outlay of funds and sometimes no outlay of funds at all.

Related posts:

• Crazy VIX:VXV Ratio Chart
• Options on UVXY and SVXY Open Up New VIX ETP Trading Approaches
• Performance of Volatility-Hedged ETPs
• Dynamic VIX ETPs as Long-Term Hedges
• New and Noteworthy: VIXcentral.com
• Third Steepest Front-Second Month VIX Futures Contango Ever
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• A Monthly Comparison of VXX and VXZ
• Ten Things Everyone Should Know About the VIX

Disclosure(s): long VIX at time of writing