Fear Factor

After observing the potential for higher interest rates last summer, for example, I'm sticking with many of the floating-rate preferreds I've since written about. The continued strength across almost all issues, along with weak bond prices, has kept this a trade in which I'm comfortable maintaining in the current market environment.

With regard to new money, I always wait until a truly compelling idea floats across my screens. You can't be in a rush in this game. It might happen this week, or next month, or next year, but that's the only way to trade.

One new position I've recently put some money into is fear, or more specifically, volatility. Given the slew of worrisome issues facing the economy — higher commodity prices, interest rates and the potential for Iran going nuclear — you'd think investors would be showing signs of nervousness. Yet fear, at least as measured by the volatility of options prices, has yet to materialize.

And although managing fear has always been a regular part of the trading game, traders of all sizes can now tweak their exposure using a number of exciting new exchange-traded products that turn fear into an asset class unto itself. Although professional investors, primarily options market-makers, have long traded volatility through complex spreads on index options, the Chicago Board Options Exchange also offers a clean and transparent method for individual players to take positions with ease. This isn't buy-and-hold, mutual-funds-for-dummies-type stuff. If you aim to be operating on the edge, trading volatility puts you smack dab on a new frontier.

The majority of the volatility-linked derivatives are based on the CBOE's Volatility Index, or VIX, which was first tracked on a real-time basis in January 1986. Initially tied to options on the S&P 100 index, the VIX was originally designed not as a trading instrument but as a shorthand way of expressing the overall volatility level of stocks. Because it tends to rise when stocks fall, the VIX quickly became known as the "fear" index.

In September 2003, the CBOE revised its methodology with the intention of creating a tradable instrument that would allow traders to make an outright bet on volatility itself. The new VIX is based on the widely followed S&P 500 index instead of the lesser known S&P 100. Also, the VIX is now calculated using a weighted average of all options traded, with the weighting determined by the degree to which the options' strikes are either in or out of the money.

So how can you trade the VIX? The most advanced (and highly capitalized) traders might take a look at VIX Futures, which allow long or short positions on the 30-day implied volatility of the S&P 500. Traded electronically on the CBOE's Chicago Futures Exchange, VIX Futures are cash-settled, so unlike futures on corn or soybeans there's no physical delivery. If you hold a contract until expiration, your account will simply be credited or debited the difference between your purchase (sale) price and the settlement price.

Of course, the vast majority of traders doesn't hold contracts until expiration; rather, most traders offset them. Volatility is, not surprisingly, highly volatile! According to the CBOE, near-term VIX Futures have shown a historic volatility based on daily return of approximately 45%, compared to 32% for Google (GOOG) and 10% for the S&P 500. This is a security designed to trade.

VIX Futures trade in fluctuations of one-tenth of a point, with each tick worth $10. So if you go long the May contract at 129.5 (which equates to the VIX at 12.95), and it goes to 129.6, you make $10; at 130.5, you make $100 (less commissions). Of course, a move in the opposite direction would result in an equal-sized loss. Margin requirements start at $2,250, reasonable compared with popular futures contracts such as the eMini S&P 500 or e-CBOT Mini-Sized Dow. Launched in March 2004, the contract appears to be gaining momentum. In recent weeks, the exchange has reported record volume of more than 8,000 contracts traded. Open interest in VIX futures stands at over 21,000 contracts, indicating more than enough liquidity for a small-sized speculator just getting into the game.

A less aggressive way to bet on volatility would be to use the recently launched VIX Options, the first product on market volatility to be listed on an SEC-regulated securities exchange. This means that, unlike VIX Futures, VIX Options can be traded from any standard stock account approved for options trading. This is a significant development: It's now possible to buy puts and calls on volatility just like you'd them on Microsoft (MSFT) or any other exchange-listed issue.

There are a number of differences, however, between trading options on a stock and trading options on volatility. Most notably is that while volatility can fall, unlike a stock it can't go to zero. Because volatility tends to rise when stocks drop, one would expect that most investors would use VIX Options as a hedge (albeit an imperfect one) against a precipitous decline in stock prices. If the Dow dips 200 points in one day, the VIX will undoubtedly experience a sharp spike.

VIX Options are currently listed in through February 2007, with strike prices ranging from 10 through 20. The November 2006 17.50 call, for example, recently traded at $1.50 per contract. If volatility spikes sharply before this fall, contracts such as these could experience a significant surge.

Moreover, the recent range of the VIX suggests volatility might be cheap. From 1997 through 2003, there wasn't a year in which the VIX didn't eclipse the 30 level; in fact, it surpassed the 40 level several times as well. Yet 2005 was a year of almost unprecedented low volatility, with the VIX maintaining a range of between 10.23 and 17.74.

Volatility trading is still in its infancy, and not surprisingly critics abound. Naysayers suggest volatility is, in essence, a description of an asset's return, not an asset unto itself. Yet most market players adopt the perspective that if it has a price, then it can be traded. And given the increasing number of dangers on the horizon, allocating a conservative portion of your capital to volatility is a trade I happen to think will pay off in spades. With it, you'll have nothing to fear including fear itself.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.