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It's Time to Buy Volatility

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For the first time in over four months, options, or implied volatility, is inexpensive and represents a buying opportunity.

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MINYANVILLE ORIGINAL A few weeks back I wrote on the Buzz & Banter (subscription required) about how the VIX (^VIX), the de facto gauge of perceived market volatility and risk, was actually relatively high and expensive despite the seemingly low absolute value near 15.5 which was near a five-year low. But now, for the first time in over four months, I believe options or implied volatility is inexpensive and represents a buying opportunity.

But we do not want to use the VIX, or its related products such as ETFs or ETNs like iPath S&P 500 VIX Futures (NYSEARCA:VXX) or leveraged products like Velocity Shares 2x VIX (NYSEARCA:TVIX) as the vehicle. Instead we will go right to the source: the SPDR Trust (NYSEARCA:SPY) options.

I'll get to the strategy in a bit, but first I want to define volatility and the VIX and give some reasons why I think it is "cheap" right now.

The first and foremost thing to keep in mind when looking at the VIX is that it is a statistic, and as such it tends to revert to the mean. While demand can drive values higher, keep in mind there is unlimited supply of the options contracts upon which the VIX is based. This pricing, or short-term implied volatility levels, is based mostly on short term perception of risk rather than on some long term fundamentals.

The biggest misconception and misuse of the VIX is that implied volatility is a distinct asset class that can be traded or used to hedge a portfolio. It is not predictive, only reflective of current conditions. Let's take a look at exactly how the VIX is calculated.
No positions in stocks mentioned.

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