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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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Implied volatility and SPY options are still inexpensive on a relative basis to the realized or historical volatility. And yes, it is also low on an absolute basis, at 13% level; meaning even if it doesn't lift, we'll only be jumping out the ground-floor window and end up mainly bruised by time decay.

Buying Both Puts and Calls

I realize that VIX and the products based on it have become extremely popular, but I think they are too complicated for most retail investors to use them as a hedge successfully. It starts with the fact that, as described above, these are derivatives on a derivative. This creates a certain dampening effect making pricing behavior extremely hard to predict and often ineffective or disappointing in the performance.

Even institutional investors or hedge funds that can run some complicated strategies seem to lack a full understanding of how these products work. In fact it was professional money managers loading up on VIX futures and ETFs that drove the steep premiums and term structure described above. I don't think they realized just how much they were overpaying for that supposed "protection."

My approach is to simply buy the options on which the VIX is based, thereby not adding an extra layer of something I need to be right about; namely, how futures will respond to current events. Buy purchasing relatively short term options, I know that if there is a spike in realized volatility there will likely be a commensurate, if not greater, spike in the implied volatility of the options.

Last week I established a position in SPY by purchasing a diagonal calendar spread on the call side and a ratio back spread on the put side. Both of these are long volatility or vega positions, meaning they will benefit from a strong directional move. But the put position has much greater exposure to a pop in implied volatility. The thinking here is that on a rally, IV will probably not increase too much. However, on a sharp decline, the fear will kick in and IV will in fact spike. Let the fireworks begin.

Twitter: @steve13smith

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No positions in stocks mentioned.

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