How to Profit from Market Volatility

Jelly Roll Capital Equity Research

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Dissecting the New Market Volatility

The lack of updates on the site this week is largely as a result of needing some down time following the release of the American Eagle Outfitters (AEO) Stock Report. Be sure to give it a read - I believe American Eagle is a great business and brand name selling at a discount to fair value.

For now, I’d like to address the market volatility from two perspectives - one heavily statistical and trading-oriented, and the other from a more qualitative and long-term approach tomorrow.

Market volatility, as measured by the CBOE Volatility Index (VIX), is at a 52-week high. Many of the CNBC-type soundbites from this bull market - terms like “awash in liquidity,” “double-digit earnings growth,” and “low volatility environment” - have become taken for granted. Much of that complacency (which is evident by a low VIX reading) has been shaken out in the past few weeks, and the VIX quickly rallied to new highs. To put this into perspective, the current VIX reading of 28.3 at Friday’s close (or higher) has only occurred on 9.3% of all trading days. While that might not sound too extreme - what is once every eleven days? - the lumpy distribution of occurrences is quite striking, as seen on the chart below. Every black line represents a day where the VIX closed at or higher than it did on Friday.

Obviously there is a clustering effect with high volatility taking hold for a period of a couple weeks to a few months before subsiding. Because volatility tends to rise as the markets fall, being “long” volatility is a way to hedge your portfolio. I’ve seen volatility hedging discussed, but I’m not interested in hedging with volatility right now. Actually, I’d prefer to speculate on the short side of volatility - which you could do by setting up a synthetic short position by selling a call and buying a put at (or near) the same strike price. While this can be dangerous if you build your position into a tower of leverage, having a straight synthetic short on a fairly distant month’s calls (I’d prefer November or December right now) looks to be a high probability setup as a downward break in the VIX should occur between now and then, allowing you to profit handily thanks to the leverage of the synthetic position. I’ve modeled out a few possibilities, and the November 18s look to have adequate liquidity to work in a short call and a long put. Break-even there would come as the VIX goes under 23, and looking for a 35% drop in the VIX to 18 gives a target profit for the trade of $470 per synthetic position (one call and one put) on a $470 credit (the trade is cash flow positive).

I’ll admit that this is an unusual trade suggestion because:
1. I don’t normally do trade suggestions
2. Shorting volatility has gotten many bright people in trouble (see: Long-Term Capital Mangement)

Still, as I increase the volatility close parameter up, there is a rapid decrease in probability VIX continues higher. See the chart below for an idea of how increases in the VIX fall off.

What does this all amount to? Odds are heavily in favor of the VIX falling in the very near future, and hence it might be prudent speculation (not an oxymoron) to examine ways to profit from such a move. Buying puts is quite obvious, but given that the VIX is not a tradable index, I thought it would also be good to highlight the usefulness of synthetic stock positions here.