The S&P 500 is within spitting distance of the 2007 highs. Remember 2007 when the economy was rolling along and everyone used the equity from their first house to buy a second or, third? Home ownership became everyone’s entitlement - the American way. Five years of deleveraging later and we’ve figured out that corporations know how to manage their businesses better than the bureaucrats know how to run our economy. Corporate balance sheets are healthy and Interest rates are at all time lows. Unfortunately, the government can’t figure out spending for a quarter, let alone an entire fiscal year.
We have written extensively on the topic of using stock index futures to hedge your retirement account. Typically, the response is, “How can I sell something I don’t own?” This week we are going to discuss Volatility Index futures. This is a product offered by the Chicago Board Options Exchange and it trades opposite the stock market. Therefore, buying VIX futures provides protection from a downdraft in the stock market while simultaneously limiting the risk of the hedge position.
First, it’s important to understand that volatility in the stock market is primarily associated with fear. Stock market declines put fear into the market’s participants. Fear generates wild swings in the market. Therefore, volatility increases with fear. The stock market collapse of 2008 was even wilder than the post tech bubble crash of 2000. The winter of 2008 saw the average monthly range in the S&P 500 increase to more than 145 points per month. This meant that the stock market had an average range between the month’s high and low of more than 20%. This continued for eight consecutive months.
VIX futures trade monthly and they are a direct measure of the volatility expected within the next 30 days. Therefore, if the price of the VIX futures is 17.00, the market expects that the S&P 500 futures may move as much as 17% over the next 30 days. The all time high for the VIX futures is 80.86, set in November of 2008.
This leads us to the second point. Fear is an emotion. Emotional actions exceed rational behavior in the markets. The all time high in the VIX futures suggested that the market could be priced more than 40% higher or lower from the prices we were trading at the time within 30 days. The S&P 500 closed at 812 in November of ’08. The VIX price suggested that by Christmas, we could’ve been trading as high as 1136 or as low as 487. The reality was that we traded from a low of 730 to a high of 836 in December of 2008. Clearly the imagination of the market’s participants got the best of them.
VIX futures are also an easy market to conceptualize in both pricing and movement. The current price is the market’s expected volatility between now and the expiration of the contract. The April VIX futures are trading at 16.50. That implies a volatility envelope of 8.25% higher or, lower. Volatility must be measured as a +/- envelope. This suggests that the S&P 500 futures, which are currently trading near 1484, should be between roughly, 1606 on the high side and 1362 on the low side when the April VIX contract expires. The all time high for the S&P500 is 1695 in March of 2000 and the market hasn’t traded above 1600 since September of 2000.
The pricing of VIX futures is simply $1,000 multiplied by the index level. The April VIX futures trading at 16.50 has a full contract value of $16,500. This represents a multi year low. The all time low was 12.77 set on May 11th, 2007 while the previously mentioned all time high of 80.86 goosed the full contract value up to $80,860. May, 2007 was the same month that the S&P 500 traded back above 1500 for the first time since the 2000 tech bubble burst and should help to provide an apples to apples comparison of the relationship between the VIX futures and the broadest stock market benchmark, the S&P 500. The real key is that while the S&P 500 declined by 50% for a potential loss of $37,500 between May of ’07 and March of ’09, the VIX futures surged by more than 600% or, a potential profit of more than $68,000.
The trade that we are looking at hinges on two ideas; One, that political discord among the bureaucrats in charge of the U.S. budget will find a way to add some drama to the markets or, secondly that buying the VIX futures provides a supported position with limited risk as a hedge against another 50% decline in the stock market.
The 3.73 point difference between where the April VIX futures are currently trading and the all time low of 12.77 equals a potential loss of $3,730 dollars per contract, which is about equal to a minimal 5% decline in the mini S&P 500 futures at $3,710. However, any decline more serious than that could set the market’s emotions roiling and we’ve already illustrated the excess returns achieved through owning volatility futures, rather than outright shorting of the stock indices.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer