I follow one specific index of notable importance during tumultuous times like we’re presently experiencing.

It’s called the VIX. And it captures the sentiment of the market perhaps better than anything else.

Also known as the “Fear Index,” the VIX measures the ratio of put options versus call options being bought on the S&P 500. When the market moves higher, the VIX goes down… when the market heads south, the VIX moves higher.

[ad#Google Adsense 336×280-IA]Since the market is down double digits over the past few trading sessions, the VIX has increased by almost 100%.

Fortunately, there is a way to play the VIX… so listen up.

Back in 2009, iPath launched its S&P 500 VIX Short-Term Futures ETF (NYSE: VXX), which tracks the VIX. Thus, it moves higher as the market moves lower… and vice versa.

But don’t buy it! Like most ETFs that are correlated to options on an index, they lose value through daily “leakage” when there’s no major activity in the underlying instrument. And nobody wants to be a victim of leakage.

No worries, though… VXX does have options attached to it, which can fly when the VIX is in motion. With these options on VXX, we can position ourselves for what should be a nice payday over the coming weeks.

How the Trade Works

We’re going to play the downside on the VIX, since it has always proven to be more profitable and predictable than trying to play the upside.

You see, the VIX trades in a historical range between 10 and 90. At 10, the VIX is saying the market is complacent and stocks are overvalued. At 90, it’s saying that the market is panicking and stocks are cheap.

Understand that 10 and 90 represent the far ends of the VIX trading range. The index rarely touches either number.

Since April, the VIX has been trading in the 15 to 20 range, pointing toward complacency. The problem is that markets can stay complacent for a very long time – even years. Such a reality makes playing the upside on the VIX very difficult.

The other side, when the VIX trades at 90 (like it did during the financial collapse of two years ago), is an easy call.

Although the VIX has only traded at the 90 level once – at the market bottom in 2009 – on many other milestone sell offs it has traded between 40 and 50, like it did on Monday when it touched 48.

[ad#article-bottom]Here’s the rub… Historically speaking, within a few weeks of the VIX trading at this level, the market has rallied, and massive profits have been made by going short the VIX… or going long S&P futures. This time should be no different.

Barring some major panic in the world market, look for the VIX to retreat back to the 20 to 30 range within a few weeks… or even days.

Recall, the market has reversed course on every occasion in the past, except once, when the VIX approached 50. (There’s always that one exception from two years ago to keep us all honest.)

With history as our guide, betting against the VIX by buying put options on VXX – or even call options on the S&P – should give us a high probability of seeing a profit in the days ahead.

Ahead of the tape,

— Karim Rahemtulla

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Source:  Wall Street Daily