Prepare for the Next Major Market Move With an Instant Income Boost

Despite a brief decline that occurred in early November, stock market prices are almost exactly where they were the day of the presidential election. When prices trade within a narrow range, indicators that measure market volatility will generally decline.

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Volatility has fallen to six-month lows by some measures, and whether prices rise or fall it seems likely that volatility will rise soon. Selling a put on an ETF that tracks volatility could generate income while we wait for prices to begin their next trend.

Put selling is a strategy traders can use to generate income and acquire stocks at what they consider to be a fair value. Income is received immediately when the trade is entered. If the price of the stock or ETF is above the options exercise price at expiration, then the trader keeps the income as their profit. If the stock or ETF falls below the exercise price, then the trader will be required to buy it at the exercise price. You should only sell puts on stocks or ETFs that you would like to own and with exercise prices that are at or below what you think a stock is worth.

It is probably not possible to place a precise value on what volatility should be worth at any time. However, we can describe volatility as high or low. Like any other trade, we want to buy low and sell high.

One way to look at volatility is with the CBOE Volatility Index (VIX), which usually increases when stock market prices drop and decreases in bull markets. VIX is calculated based on the premiums traders pay for options on the S&P 500 index. The chart below shows that this value moves up and down and is currently at a level that seems low.

The Bollinger Bandwidth is shown in the center of the chart, and this measure of volatility has fallen to a new 52-week low. The stochastics indicator shown at the bottom signaled a “buy” in VIX.

Volatility is not a buy-and-hold investment. VIX is designed to be used by traders, often used as a hedge against a market drop. When risk is high in a market and VIX is cheap, buying a small amount of volatility can protect a portfolio against a large loss. VIX can be traded with futures contracts, and ETFs that track VIX are also used by traders.

ProShares Ultra VIX Short-Term Futures ETF (NASDAQ: UVXY) is an ETF that uses leverage to try to capture twice the daily move of the VIX. It is currently trading near $20 and has seen a 52-week low of about $18.20. Like VIX, the Bollinger Bandwidth is low, indicating a large price move is likely, and the stochastics is bullish, indicating that a move should be higher.

UVXY Chart

January $16 puts can be sold for about $0.95. Most brokers will allow you to open this trade with a margin equal to 20% of the exercise price, or $320 for a put option on 100 shares. If UVXY closes above $16 at option expiration on Jan. 18, the premium of $0.95 will provide a profit of almost 30% based on the margin amount.

If UVXY is trading below $16 at expiration, you would own volatility at a time when the market is likely to experience a spike in volatility. If the option is exercised, the ETF would most likely be a sell fairly quickly. Selling UVXY above the strike price less the premium received for the option sale, $14.95 in this case, would lead to a profit on the trade if the put is exercised.

There will soon be a significant announcement from Washington about the fiscal cliff. Stock prices could become more volatile when that news comes or shortly after the announcement when the impact of any deal is assessed by traders.

Selling puts on volatility is a way to take advantage of the uncertainty in the market. Volatility tends to spike when prices move quickly. VIX is low now and selling puts on UVXY is a way to trade low volatility.

Recommended Trade Setup:

— Sell UVXY Jan 16 Puts at $1.50 or less
— Do not use a stop-loss
— If UVXY is trading above $16 at expiration, the profit on this trade will be 100% in five weeks