Back on March 11 I mentioned an opportunity in the Market Vectors Russian ETF (NYSE: RSX). At the time, President Vladimir Putin’s incursion into Crimea was the ongoing headline and as expected, the ETF was selling off…hard.
The ETF was nearing all-time lows and the fear was palpable. Implied volatility, which measures investor fear, was nearing record highs in the ETF. No one wanted to take a chance on Russia.
But it’s opportunities like these that investors should actively seek out. Those who did take a chance on Russia have made 13.8% in RSX over the past two months.
Now the market is offering another interesting contrarian opportunity.
Volatility, as measured by the VIX, has pushed into a long-term extreme oversold state.
According to a recent article in Barron’s, volatility hasn’t been this cheap in over eight years. In fact, implied volatility on the one month at-the-money VIX options is the lowest in history.
Esteemed analyst Jason Goepfert recently posted a chart backing up Barron’s claim.
Mr. Goepfert states, “Of the 45 days that the VIX had dropped below 45% (seen in green), three months later the VIX was higher 42 times (93% of the time) with an average change of +21%. The three days that showed a decline in the VIX, in November 2006, soon reversed course and saw a higher VIX.”
So, if we think implied volatility as seen through the VIX is ready to pop, how can we take advantage like we did in RSX?
Since you can’t buy the VIX outright, the easiest way to take advantage of the situation in the VIX is to buy VXX, or the leveraged UVXY. However, in my opinion, there are far more effective ways to profit from the current oversold state of the VIX…without actually buying low volatility.
The first is a strategy known as a bull put spread. The goal of selling a bull put spread, also known as a vertical put spread, is to have the stock or ETF close ABOVE the put you sold.
So, if UVXY is trading for $41.30 we would want the underlying ETF to close above our short put strike of, say, $36.
Take a look at the options chain for UVXY below. If we sold a put at $36 for $1.00 and defined our risk by purchasing the $35 strike for $0.70, we could bring in $0.30 on the trade. Our return: 42.9%.
All that has to happen is UVXY must close above $36 at the time of expiration, in this case June, which is 29 days away.
UVXY could move 12.8% lower and we would still make the 42.9%. That’s right, we could be completely wrong in our directional assumption and still make a profit. And the trade has a 73.78% probability of success. We could increase our probability of success to 79.34% by selling the $35 strike and buying the $34 strike for roughly $0.22. That would give us a return of 28.2%.
Investing using alternative methods is the wave of the future. Investors now have the ability to choose their own probability of success on each and every trade they place. And low volatility is offering the perfect opportunity to use such methods. But remember, like any investment, keep your position size at a reasonable level.
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