Is Buying Call Options on the VIX a Sensible Play Now?
There are various strategies that we can use to manage a stock market plunge. One of these are playing the VIX, and using options is one way to do this. Does this make sense now?
The volatility index is a tool that a lot of people use to measure market sentiment trends in the next 30 days, even though you can just look at the market itself to get a good idea of this.
Volatility is the tendency for things to move, and higher volatility means bigger movements and lower volatility indicates that movements in price will be smaller. We can measure the volatility of anything directly, and people do, but there’s also a volatility index maintained by the CBOE based upon the movement in options prices.
The thinking here is that options prices are somehow more informed and we can get a glimpse of the future a bit by looking at options rather than just market volatility directly or the volatility trends of a particular instrument we’re looking to track.
This is a myth though because whatever happens to these options is based upon what’s going on in the markets and options traders do not have access to any secret information that the market as a whole is not privy to. Just because something doesn’t make much sense doesn’t mean that people won’t try to make some out of it though, so this view that the volatility index actually leads the market persists.
Even knowing that the market will be more or less volatile doesn’t really tell us much as this is a neutral indicator by design and it therefore doesn’t tell us what direction that a move will go in. This is called the fear index though and we know that fear produces more volatility than exuberance so a higher VIX does at least suggest that we need to be more careful if we are riding the long side.
If we think that the market may tank, we may wish to buy call options on the VIX so that if things really do get out of hand and we crash, this will send the VIX rising significantly and we can hedge our losses in the market. In this case, we’d be using the calls as insurance against wild volatility, abrupt moves in the value of our portfolio to the downside that we may not be able to manage simply by monitoring our positions normally.
This is the true value of such a hedge, not to just use it to cut our losses generally when we should be exiting our positions instead, but to hold the option as protection against a genuine black swan event that is neither foreseeable nor manageable.
This is not how these things are used a lot of the time and there is a pervasive idea that hedging should be used to try to make up for bad trade management. You might see a persistent bear market where we should have exited long ago, with people clinging to both their hedge and their main positions and feeling somehow that what they are doing makes sense.
Options Trading is Not for Amateurs
Options trades can either be used as a hedge or for speculation purposes. The small percentage of Investors that trade options limit themselves generally to hedging with options, because this is a trade and they aren’t traders. If they were willing to speculate on options, they could also speculate on their main positions and trade them that way, but they instead may use them as insurance. Trading options requires considerable skill, where using them as a backstop is at least a much simpler process.
We need to be careful though not to pay too much of a premium for this insurance, even though with hedging we are using a lot of room between the asset’s current and strike price and therefore the cost will be pretty low. The main problem that people run into here is that they believe the value of the options hedge is to allow them to stay in their positions, where almost always there are better ways to hedge, just getting out for instance when the heat starts to rise too much, well below what would be required to trigger an options hedge.
Once again, we should only be hedging things that may happen when we’re not looking, and extending this to the time where we are looking just doesn’t make sense. If we are willing to trade options to take action to manage our risk, we should also be willing to trade our positions when required as well in order to do so, and then limit our options trading to when we cannot.
When we do this properly, we will see that the value of these options is a lot less than we think and we end up chasing monsters over and over again, with the cost of this chase being the options premium.
When we do this with the VIX, this is even more removed from our positions, and we could instead just buy puts on stock indexes, which at least will have us in the same asset. The VIX is famously spastic, and can bounce in a way that is pretty wild, like the 15 to 20 channel that we’ve been in over the last 2 months.
This is not an easy index to trade at all and requires full-time diligence and time frames that are only really suited to the full-time trader. You can do well trading this index on intraday charts but this is not something we want to be trying to predict further out than moves lasting a few days because of its volatility and swinging within ranges.
To suggest that anyone but a full-time trader speculate on the VIX might be as far out of an idea as we could think of, but Jake Weinig, a partner in hedge fund Malachite Capital Partners, is suggesting that we actually do this, and speculate with buying options no less.
Buying $20 Call Options on the VIX Right Now to Speculate is Pure Gambling
His idea for us to buy $20 call options on the VIX is not put forth as a hedging option but one that we may use to look to make a profit. When we buy calls, we need more behind the strategy than thinking that Donald Trump is rocking the markets and maybe all heck will break loose and we can make a nice profit from it.
$20 is the upper edge of the range of the VIX these days, and the chances of us moving much past that to rake in some real loot and it being there at a given point in time such as options expiration day is both unlikely and involves a big guess.
It’s not that this doesn’t get much above 20 here and there, it’s that it doesn’t stay above for long. You may even be holding this as it climbs into the money and with some time left you hang on for more and it ends up finishing out of the money and worthless anyway.
We might think that we could just time these options trades but that’s a skill that only sharp option traders have, and this is perhaps as far away from the average person in the market as you can get, so we can’t just tell them to watch and monitor and be very quick to exit if we get in the money and don’t look like we’re going to stay there.
For all of the volatility that we’ve had this year, a fair amount to be sure, we’ve only been significantly over 20, the sort that you could really score with this call, for a single day, on August 5 when we went up to almost 25. By the next day we were back down to 20 and the fun was all over. This is simply a terrible bet, and an especially terrible one if you require this one day in 240 days to happen on an exact day in the future.
Even if we were options traders, skilled traders avoid long shots such as this, as if you don’t control your drawdown risk, you won’t be trading for very long, and the lesser ones don’t. There are legions of budding traders that try options and quickly learn that they are well out of their league. Options can be traded very successfully but only by looking to gain an advantage, not by taking flyers like this and hoping your number will hit like people do with playing the lottery.
However, the lottery is plenty popular though, and some people like to gamble like this, so this doesn’t mean that people won’t try this trade after reading that a hedge fund partner likes it. A hedge fund actually may like this trade for themselves though because they can put a very small portion of their assets in it and benefit from its hedging capabilities, and hedge funds can’t just move in and out of positions like we can because of the size of them, so they need a lot more protection than we do.
This is not an idea that individuals should like though because of the fact that this really is a fringe bet that doesn’t really make sense to use as a means of speculation and there are simply better ways to hedge than taking flyers like this that we don’t really need. If the market does start breaking down, we can just jump on the short side of some index futures positions, allowing us to not just hedge but look to capitalize on the move.
We don’t want to be trading futures on the VIX though, the other way to trade it, either though, unless we are a short-term trader who really knows what they are doing and can cash out reliably on the ups and downs of this index. This is not even a good instrument for short-term traders to trade even, because there are much more reliable things to put our money in that requires a lot less guesswork, where we would be looking to ride trends that are a lot more predictable.
Last Monday saw the VIX go down, it went up on Tuesday, went back down Wednesday and Thursday, and went up a bit on Friday. Stock markets can go up and down this way as well, but do so in more predictable patterns where the VIX moves more randomly, and more randomness is not what we want in a trade.
Buying 20 calls on the VIX right now for speculative purposes is simply a crazy idea on all counts, and an especially crazy one to be considered by those who know little or nothing about trading options successfully. Those who do know a fair bit will easily recognize this as not a good trade though, but that’s an extreme minority of people in the markets.
For the rest of us, if we are daring enough to even think about such a move, there are so many other ways to help ourselves with both managing risk and shooting for higher profits, and we really should leave options trading to the options traders, as there is no free lunch here like there is in the stock market and we don’t want to be just buying theirs.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
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