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Let’s discuss Wall Street’s fear gauge and how traders can use it to inform a year-end bet on the overall market. The CBOE Volatility Index (VIX) Index , which closed Friday at 12.63 is currently approaching 5-year lows. (It was below 12 in November of 2019). Often referred to as the “fear index,” the VIX Index is a measure of the stock market’s expectation of volatility over the the next 30 days. It is calculated from the prices of S & P 500 index options. A high VIX reading signifies high expected volatility, reflecting higher levels of “fear” while a low VIX indicates low expected volatility or greater complacency among options traders. Many who observe the VIX Index when it is low look for ways to exploit an anticipated future spike in the index, but this isn’t easily accomplished because the VIX Index is a rolling 30-day forecast, not a tradable instrument. The analogy I like to make is that one cannot buy a January New York City temperature forecast of say an average of 40 degrees for the month hoping to hold that forecast until July when the average temperatures will be in the high 80s. January’s forecast is for January and July’s forecast is for July. The two aren’t interchangeable. One can trade volatility or take advantage of low (or high) options prices, but there is a bit more nuance to it. Investors can speculate in VIX futures or VIX futures options, but understanding the futures “term structure” (how the prices of various futures of different expiration relate to each other) isn’t that straightforward. One can elect to trade an exchange traded product where the futures are managed on their behalf, presumably by those familiar with the underlying process in the futures market. But the challenge is that exchange traded products often follow a systematic and rigid strategy, such as always purchasing short-dated futures and then rolling them as expiration approaches. While this can make these useful short-term trading instruments, they tend to have embedded costs and fees which erode their performance over time. Consider the following chart of the Barclays iPath S & P 500 (VXX) , an exchange traded note which is intended to track the S & P 500 short-term VIX futures total return index vs. the VIX Index itself. Clearly there is a significant correlation between the VIX Index and the short-term VIX futures, and much of the decline in VXX is a function of the decline in the VIX Index, but there is also a significant “roll cost” or “decay” associated with systematically purchasing the short-term futures and rolling them as they expire. The VIX Index is 41.7% lower than it was at the beginning of the year, however the exchange traded note VXX has fallen nearly 70% over the same time frame. So while one could use VXX over short periods to make directional bets on VIX futures, over the long-term it is not a suitable investment vehicle. Using the VIX to our advantage So if trading the VIX Index or its proxies isn’t simple or practical, how can we use what it tells us to inform our trading decisions or strategies? Let’s walk through an example of how one could. Fact #1: The S & P 500 has rallied 12% in 24 trading days. That is above the 98th percentile for comparable periods going back a century. We’re in rarified air. Fact #2: The VIX Index, which closed at 12.6 on Friday, is well below the long-term average. The index is in the bottom 15th percentile going back to its inception in January 1990. Fact #3: This is seasonally a bullish period. If one is inclined to make a bullish bet, but is reluctant to get caught “chasing” after the market has already rallied sharply, perhaps we can take advantage of the fact options prices are well below average. Why not buy call options rather than the underlying stock? For example, one could purchase the January $460 calls in SPDR S & P 500 Trust (SPY) for $7.95, which would risk just 1.7% of the cost of the underlying ETF shares. That’s considerably less than the increase in the SPY share price in just the past two weeks. The breakeven is illustrated below. Because SPY would need to rally above the $460 strike price of the call in this example, the probability of profit is slightly less than 50/50, more precisely the probability of profit for these calls is about 48%, but the risk/reward relationship is quite favorable given the downside risk is the premium spent, or just 1.7% of the underlying price. The week ahead Several names will be reporting earnings, we own two of these, Broadcom and Dollar General, which as always I’ve highlighted in green. I’ve elected to add my own Buy/Sell/Hold rating in the first column prompted in part by the fact that a few companies that are reporting I really like on fundamentals, but are not in our long-only event-driven fund. DISCLOSURES: (Long Broadcom, Dollar General) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. 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