Dancing on the Fear Spike

 | Sep 29, 2013 | 12:00 PM EDT  | Comments
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Stock quotes in this article:

spy

,

QQQ

When volatility is up and rising in markets, would you rather be a buyer or seller of option premium? Actually, you if you are a momentum player you'd rather be a buyer, especially when markets are trending up or down. Contrarily, you might want to hedge when options are cheap when volatility is flat and low. But when are the best conditions to be a seller of premium?

I have found the best time to do this is on a spike high in volatility that is far outside the norm. Often we find these extreme moves are exaggerated and reflect emotional responses to uncertainty and an unclear future. It's always better to be safe than sorry -- to buy insurance and get ready for "the big flood" that usually never happens. No one would want to lose the strong gains we've seen so far this year. Who would wish to be the last one in the room before the lights go out?

The markets tell us what to do, where to go and what direction to take. If we look at the bigger picture and refrain from making assumptions about the effects of this meeting or that deadline, our jobs and decisions become that much easier. So, when a day like Friday occurs, I see opportunity. As the session was coming to an end, the CBOE Volatility Index (VIX) was spiking to new highs, but the market really was not moving very much. Apparently some S&P 500 puts were being bought for protection in case the folks in Washington decided to shut down the government (with a deadline of Sept. 30). So how do you handle these spikes?

VIX -- Daily
Source: StockCharts.com

For most of 2013, these spikes have been temporary, and they've constituted great premium-selling moments. Just look at the chart of the VIX above and you can see what I'm talking about. Friday saw the VIX spike at the close, with a rise of nearly 10%, as market participants feared a selloff early next week. But, I've lived through the recent turmoil caused by government impotence (see: 2011 and late 2012), and I see evidence that these fears are unwarranted and have presented great trading opportunities. As an options trader, my preferred choice was to sell SPDR S&P 500 (SPY) or PowerShares QQQ (QQQ) put spreads.

When it feels the worst and uncertainty is apparent, fear rises -- and so does the VIX. The premiums rise, especially on puts, which have been the best vehicles to sell all year long. When the event passes we see volatility deflate and premiums drop. and gains can be booked as you buy back puts or spreads. We'll see next week if this was the right move, but if the market's behavior in 2013 so far is any clue, then it was probably another great chance to profit.

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