How to Trade Fear

So you have been watching this “interesting” stock market. One day down, next day up and in the end you don’t seem to find any “wealth effect” in your stock portfolio. And then there is this marvelous VIX, Uncle Ben’s bullish notes about subdued inflation, bullish economic data and you think everything seems to be going in the right direction. Then you see commodities surging, Gold and Silver making record high almost non-stop while US Dollar tanking. It’s an “interesting” market.

VIX is almost at 3 year low and headlines will give one an impression that everything is brilliant, that market participants are complacent and satisfied and that risk is almost non-existent (Well, isn’t that what Uncle Ben wanted?). Part of the story I already shared on yesterday’s site i.e. VIX futures are reflecting uncertainty in longer term as opposed to shorter term. Now, let me share a chart (via Zero Hedge) reflecting fear as measured by indices that are not’s used, generally, in mainstream media. I had heard about these indices before but frankly it was originally Zero Hedge that connected the dots first (read more here). This is sharing those dots while adding a few trading ideas.

The chart above has three indices in it. Let me explain the above chart-

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As per Bloomberg, The Credit Suisse Fear Barometer (CSFB) “measures investor sentiment for 3-month investment horizons by pricing a zero-cost collar. The collar is implemented by the selling of a 10% OTM SPX call option and using the proceeds to buy an OTM put. The CSFB level represents how far out-of-the-money that SPX put is”. The higher the level, the greater the fear.

The CBOE SKEW Index (“SKEW”) is an index derived from the price of S&P 500 tail risk. As per CBOE-  “Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the “skew”. Said another way, the higher the index level, the greater the fear.

Notice, what’s been happening to three Fear Indices. CSFB and Skew both have diverged from VIX cash index. CS fear Barometer is actually at multi year high (Yes, that includes period preceding 2007/08 too) and CBOE Skew index is also at elevated levels. Interesting.  So how do you trade it?

There are a few ways on how you can play such low volatility/skew for instance a) VIX calls (opportunistic/short term), b) TVIX (VelocityShares Daily 2x VIX Short Term ETN) which touched a fresh 52wks low today or c) VXX and or/ VXX covered call. (VXX @ $25.7 and short May 27 calls @ $1.26, bringing break-even to about $24.4/ or yield >20% if assigned).  These are just one of the few ways. Volatility instruments are relatively new, so please make sure that you know what are you trading before you invest even a single dollar.

(OPNewsletter May 2011 portfolios are up over +10%. If you would like to join OPNewsletter, pls sign-up for the waitlist as OPNewsletter is by invitation only)

Disclaimer– I am long TVIX as of this writing. But I may change my position anytime without any notice.


One response to “How to Trade Fear”

  1. prakashsi Avatar

    excellent post OP! particularly if they “release the bernakens” tomorrow then this would be a good hedge, at the least

    i personally will just buy OTM spy puts. have had a hard time ever realizing decent gains on the vix but i may look into that leveraged vix instrument

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