How to Make Money in This Mess

Investors are scrambling to figure out which way is up and what the market’s next move will be. The one thing that we can bet on in the near term is more volatility.

Savvy investors can use volatility to make lots money in a bear market.

There is a secret about the Volatility Index (VIX) that can potentially make you thousands of dollars.

What Does the VIX Really Symbolize?

Think of the VIX as a “fear” indicator. Most investors — and even some experts — don’t know how to actually use it. You may hear things like “if the VIX is high, it’s time to buy” or that when the VIX is high, people are scared.

But the real question is, how does it affect my financial investments?

Let’s first take a look at how the Volatility Index tends to react with the markets. Below you see a chart of the S&P 500 (SPY in green) compared to the VIX (in black). The two generally have an inverse relationship. When the market is rallying, the VIX is dropping and vice versa.

View larger chart

To put it simply, the Volatility Index has a direct relationship with options prices. As people buy options and the VIX goes higher, options get more expensive. When people sell options and the VIX drops, options get cheaper.

So here’s the thing… What if you bought a call option, had the stock rise, and either lost money or didn’t make as much as you thought you would? Did you ever think that a falling VIX was eating away at your profits?

If so, then you have discovered part of the secret.

Here Is How It Works

While you might think that Wall Street is manipulating option prices to make your life miserable, it is actually the human psyche that creates the VIX/stock market phenomenon.

This headline and others like it is a large contributor:

Courtesy of Marketwatch.com

When most of us first learn the markets, we are told to buy low and sell high. It is natural to want companies to flourish and stock prices to rise. The headline above is a prime example of “normal” sentiments.

When you turned on the evening news last night you heard doom, not joy, as the markets dropped almost 7% in one day. This is because it is “normal” to feel scared when markets are dropping and natural to want the markets to rise. Our emotions and influences by the media help dictate option values.

Fear drives option prices higher. Greed and complacency force option prices lower.

Happy Bulls

Most investors are “long only,” which means they buy stock hoping for it to appreciate in value. A very small portion of retail investors short stocks, and if they do, it is usually for brief periods of time.

Because the world is mostly long stock, the option markets reflect this sentiment. It creates a self-fulfilling prophecy. When the market is up the Volatility Index will be down, and when the market is down the VIX will be up… Just like the S&P 500 chart I showed you.

A big reason for this is the covered call strategy, which is the most popular strategy among Main Street investors. When stocks are rallying, it is common for investors to sell covered calls against their stock. This drives the price of call options lower.

Another popular strategy when stocks are stable or moving higher is the “short put” (this is a bullish trade discussed a bit on Friday). Here again, the sale of the put drives the prices of options (and the VIX) lower.

Since most investors are driven by greed in a bull market, they are not buying puts for protection on the way up, so there is not much support for option prices in bull markets.

All of these tendencies are driving down option premiums in bull markets, even when doom is lurking around the corner.

The VIX was at its LOWS at the end of August 2008, right before the market crashed.

The Bearish Paradox

It is not until the markets start to drop that investors panic and begin buying puts because the greed shifts to fear. This shift in sentiment happens very quickly and when stocks begin to drop, investors load up on puts to protect themselves and take advantage of the sell-off. The media often adds fuel to the fire and this fear drives put prices exponentially higher in a sell-off.

Oddly, at the same time many investors remain greedy, they believe sell-offs happen quickly and the bulls will return shortly, so they go out and start buying calls, driving call prices higher as well.

I find that bear markets not only bring fear, but drive greed at the same time. It’s very strange, but this is why investors often lose more than they should. Many believe that they can weather the storm and that pullbacks are short-lived. Unfortunately for many, that is not always the case and they end up losing excessive amounts of money.

But as I told you before, smart investors can gain an edge by knowing how this kind of volatility affects options.

Get the Edge in Your Account

Once you know how the masses tend to act, you can take advantage of their faults. You now know that options get an extra boost in price when stocks are falling. This means that puts will generally return more than calls if a stock were to move $10 in either direction. So if you are comfortable with trading them, puts offer a stronger reward.

It is also wise to buy puts when the market is overbought but still moving higher. Then you can take your profits when the market drops. This is like buying insurance… You buy before you need it. When panic ensues, you can be the one cashing in.

Once the markets start to turn around, you can get bullish by selling those “insurance policies.” So here’s a tip for the turnaround: If you are selling puts because you want to get bullish or eventually buy the underlying stock, sell the put on a down day when the VIX is spiking. This is when options prices are super high, and you can maximize your returns!

I have to caution you… the selling is not over. Mistakes and irresponsibility in Washington have set us up for another recession.

Editor’s Note: While most Americans struggle for survival, some smart folks could discover a safe, simple way to turn the ongoing recession into life-altering potential gains! By reading Safe Haven Investor you could join them and get your share…

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Other Related Topics: Jared Levy , Market Analysis , Option Strategies Weekly , Options Trading , Stock Market , Volatility Index

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