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Tuesday, August 28, 2012 - 15:00
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Tuesday, August 28, 2012 - 17:24
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Tuesday, August 28, 2012 - 15:00

A Virtually Guaranteed Winner in a Very Dull Stock Market

Tuesday, August 28, 2012 - 3:00pm

As traders, we can take advantage of the late summer doldrums in the market and open a trade that is virtually a guaranteed winner. Volume has all but disappeared from the stock market -- it seems Wall Street is on a vacation. Analysts expect volume to pick up after Labor Day. Until then, it is likely to be a dull market.

Along with the drop in volume, volatility has also fallen in this market. Volatility is often measured with the Volatility Index ($VIX), which is also sometimes called the "fear index." VIX tends to spike higher when the stock market sells off sharply, and peaks in VIX are associated with lows in the S&P 500 index. The chart below shows VIX during the past three years. The highs and lows are easy to spot and right now, we are near a low.

VIX is shown in the chart along with the average true range (ATR) indicator. ATR is an indicator that can also be used to view volatility. For this chart, we are looking at the volatility (ATR) of the market's volatility (VIX). While prices seem to move randomly, VIX actually follows a basic recurring pattern.

In the center of the chart, the ATR is taken during a period of 14 weeks. That view shows that VIX follows a very cyclical path -- low values are always followed by high values, and highs slowly drop back to lows after a time.

This pattern of low-to-high and high-to-low is highlighted at the bottom of the chart, which shows the one-week ATR. Low values are followed fairly quickly by higher values. While VIX can stay at very low levels for several weeks at a time, we can take advantage of the expected move up by implementing a simple trading strategy. When VIX falls, traders should buy volatility knowing that at some time in the future, VIX will move higher. For patient investors, this trade can't lose.

The exact timing of volatility moves, just like with price moves, is unpredictable. It is possible volatility could move higher tomorrow, or after Labor Day, or sometime next year. Because the timing is impossible to know with certainty, I view low VIX as an income opportunity.



There are futures, options, and exchange traded notes (ETNs) available on VIX. An ETN is very similar to an exchange-traded fund (ETF), but it is backed by the issuer's credit, rather than individual stock holdings like a traditional ETF. Because it is backed by the issuer's credit and credit ratings of large banks are routinely downgraded, some traders prefer to stay away from ETNs. But no ETN has ever failed, even in the market turmoil of 2008 and 2009, so I am confident that they can be traded. There are times when ETNs can move erratically and trade at high premiums or discounts to their underlying value, however, these moves represent special trading situations, and should be avoided.

iPath S&P 500 VIX Short Term Futures ETN (NYSE: VXX) is backed by Barclays, the issuer of all the iShares ETFs. I think Barclays offers as much safety as you can find in the ETN world and it is safe to trade VXX. Selling puts on VXX offers some income and if volatility remains low, we will end up owning VXX. Since buying volatility at a low price is a guaranteed winner at some point, the prospect of owning VXX is appealing in itself and I don't think of that as a major negative factor in this trade.

With VXX near $11.75, I like the idea of selling September puts with a strike price of $11. Those puts are trading at about $0.68. If exercised, we would own VXX at about $11.07 a share which is below its 52-week low. If the put is not exercised, we earn about 28% over the next month in a fully-margined position. Even without using margin, this trade will generate income of about 5.8% in the next month. If we could do that every month, we would enjoy a total return of more than 70% a year.

Volatility will eventually increase and when it does VXX will go up in price. Selling puts on VXX offers income now in a boring market and lowers the price we'd pay for VXX if volatility remains low after Labor Day, something I think we are unlikely to see.

Action to take -->
I recommend selling September $11 puts on VXX without a stop-loss. The options are expected to expire worthless, leaving a gain of the sales price in your account.

This article originally appeared on TradingAuthority.com as A Virtually Guaranteed Winner in a Very Dull Stock Market.

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.