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Protect Against Volatility: Don't Be So Quick to Nix the VIX


System volatility is at an all-time low -- but you still need to watch out for event-day turmoil.

This article was originally posted on the Buzz & Banter where subscribers can follow over 30 professional traders as they share their ideas in real time. Want access to the Buzz plus unlimited market commentary? Click here to learn more about MVPRO+.

On Thursday and Friday, there was a lot of commentary on the impending right shoulder in a possible head-and-shoulders pattern in the Nasdaq 100 (INDEXNASDAQ:NDX). This pattern is bearish. Buzz & Banter contributor Branden Rife provided a breakdown of the pattern with targets here [subscription required]. To summarize his chart, a break of the 3415 to 3420 neckline on the NDX projects to around 3092, while a close above 3628 negates the pattern.

As always with speculative bets, and thanks to an increase in volatility in tech stocks, I enjoy using butterfly spreads. Since it's speculative, I set up the trade to win big if I bet correctly and lose small if I don't.

I'm bidding for the $85/$83/$82 1x3x2 PowerShares QQQ Trust ETF (NASDAQ:QQQ) put fly expiring on May 17 (monthly expiration).This means that I am buying one contract at the $85 strike, selling three contracts at the $83 strike, and buying two contracts at the $82 strike. The butterfly trade can be done for a $0.12 to $0.18 debit. The max profit is $1.80 if it lands on 83 at expiration per butterfly, but a more realistic goal is a $1 profit if QQQ is between $82.55 and $83.87 on expiration. The max loss is the cost of the butterfly if the price is above $84.87 or below $82.05 on expiration. An $85.63/$83.63/$82.63 put fly would offer a slightly wider profit zone at a slightly higher price. Similar structures laddered below would provide entries at slightly lower costs while moving the profit range lower. I view this as quasi-portfolio protection for my small amount of equity holdings.

I'm also looking at short-term call spreads in the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). I've always stayed away from this and all Volatility S&P 500 (INDEXCBOE:VIX)-related products because, by design, they're flawed and will trend toward zero. However, because of the Federal Reserve's forward guidance, system volatility has declined to record lows across all assets. Last week's 70-pip range in EURUSD was the lowest on record (sources: Predicted Markets and Rareview Macro). But that low volatility is deceiving. Event volatility has dramatically increased to levels that dwarf the one-day events that took place with LTCM, Lehman, and others. Therefore, I think it provides opportunities to buy volatility protection around event days and sell afterward.

Twitter: @MichaelSedacca

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No positions in stocks mentioned.

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