The CBOE VIX index known as the “Fear Index” is the measure of the amount of PUT buying in the S&P500 index. It is referred to as the fear index because if the stock market investors fear that the S&P500 will go down in the future they may buy downside protection to lock in their gains. This downside protection takes the form of PUT Option contracts.
On December 31st and Jan 1st we saw the S&P500 surge over 3% which has knocked the VIX to a 5 year low. This indicates that investors do not fear the fiscal cliff and the economic future of the U.S.
But are these investors wise. The U.S. has a very difficult time ahead including higher taxes, no real increase in income which will lead to decreases in consumer demand and lower earnings for U.S. companies.
The are 2 possible scenarios which can be played for profits.
Scenario 1 below suggests that the market participant are correct and the S&P500 will move on to new highs and the volatility index will move sideways with low volatility.
Scenario 2 below suggests that the market participants are incorrect and we are at a critical turning point whereby the market retreats from its current level and moves down towards March and beyond. In this instance we should expect to see more protective puts being placed on the S&P500 to lock in gains and see a surge in the VIX.
How do you play these scenarios?
With scenario 1 you can simply believe that the S&P500 and indeed the general market will continue to advance and buy Calls on the S&P500.
With scenario 2 you could buy Call Options on the VIX although they are quite expensive as 30% of the cost of the underlying index for the $14 March 20 Calls. You could even start buying your Puts on the S&P500 now.
The choice is essentially down to what you believe will be the outcome.