I've been writing about options in one forum or another for something like 10 years now. And I'd venture the most common bit of advice I've given is this: Don't Try to Catch the Bottom in Volatility.
I bring this up because it is yet another moment in time when it feels like the entire world wants to make sure they catch the bottom in the CBOE Market Volatility Index (VIX), whatever that might mean.
Here are several reasons why it's a generally bad idea.
The cheapest VIX you can own now isn't the 12.5 you see on the board next to the symbol "VIX," but is rather the 14.45 March VIX future. And all that gets you is a 30-day window before your cash settles out, a window in which you need a two-point VIX rally just to break even.
As you can see on the graph, if you want more time for that VIX rally you're sure is going to happen, you're going to have to pay more and more premium. Go out three months, for example, and that VIX "bottom" you bought is four points above the actual VIX. Another way to look at this is that everybody "knows" the VIX is going to rally, and the market is already pricing that in.
Yes, the whole complex will lift if the VIX moves significantly higher. But the gains in a tradable VIX product will severely lag gains in the VIX itself.
2. All exchange-traded notes (ETNs) that attempt to track VIX in some fashion are a tad … awful; bashing the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) is about the deadest horse out there. For these purposes, just remember the VXX over time behaves like an index put, and thus will lose value in any backdrop short of a VIX rally.
3. You can lock in the volatility implied by the current VIX if you buy S&P 500 Index (SPX) or SPDR S&P 500 Trust (SPY) options. But those are actual options, and there are more variables than just implied volatility. There's direction, so if you take buying volatility as simply buying puts, you're at risk that the market keeps grinding higher. Even if implied volatility ticks up, you still lose.
There is also "time." If you buy volatility via delta-neutral purchases such as straddles and/or strangles, you lose money in time decay each day. You can try to offset the cost by buying and selling SPYs or E-Minis and trading against your long gamma, but that generally only works if the realized volatility in the SPX exceeds the implied volatility you paid for the options. And that's currently not the case. The 10-day realized volatility in SPY is 8.5 now, and has gone as low as 4.5 in the past month. The last time it exceeded the current VIX level was mid-January, and that was just a lagging number thanks to a couple of volatile days around New Year's. So basically, options have overpriced realized volatility for the entirety of 2013.
The best idea? Miss the bottom in volatility. There's nothing wrong with using puts to hedge a portfolio. In fact, it's a solid idea if it fits what you're trying to accomplish, which is hopefully a reduction in risk. There is something wrong with trying to act like a hero and time the market perfectly. Leave that to the tele-pundits.
Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.