I told you yesterday that September would be a volatile month – and then the market showed us just how volatile it could be.
September trading sees the largest jump in volatility across the market for the whole year, despite what you've heard about October.
Of course, most investors react to that by thinking they need to sell everything and ride out the month with cash buried in their backyards.
Wrong again. Say it with me three times: "Volatility is my friend."
Volatility always results in opportunities because it means that stocks and the market as a whole are making fast and aggressive moves. As I always say, "Trading success and a little bit of luck always prepares the prepared trader."
Now, in my last article, I broke down how September is laden with volatility, but I didn't give you the details on how to turn volatility into your friend over the next four weeks.
With that in mind, let's get you prepared for September's volatility with three different trades…
Trade No. 1: ProShares Ultra Short S&P 500 ETF Will Offset the "September Effect"
First, let's look at a volatility trade that any investor can and should utilize. I mean, I've even recommended this investment to my mom when the markets turn volatile.
The simplest of the inverse ETFs, the ProShares Short S&P 500 ETF (NYSEArca: SH) does one thing: It largely mirrors the performance of the S&P 500 – but in the opposite direction with a leverage ratio of 2:1. In other words, if the S&P 500 declines by 1% in a day, the SDS shares will appreciate by about 2% (and vice versa).
This makes hedging a portion of your portfolio a very straightforward investment. Every dollar that you invest in the SDS shares offset each two dollars lost in a portfolio invested in S&P 500 holdings.
SDS shares are currently trading at $15.25. Buy the ProShares Ultra Short S&P 500 ETF (NYSEArca: SDS) using a limit price of $15.50. Use a target price of $20 for this hedge, which would return almost 30% on a 10% to 20% decline in the S&P 500.
Trade No. 2: Hedge Away Risk from a More Aggressively Positioned Portfolio with "Shorty"
My eye is always on the Russell 2000 Index for one important reason: It's the "canary in the coalmine" for the "risk on" trade.
Markets are driven higher by speculation, which is why the Russell 2000 almost always leads a market rally higher. In the same vein, the Russell 2000 Index typically falls much faster than the S&P 500 when things start to get volatile.
This relationship – between small caps and the rest of the market – means that the Russell 2000 will naturally decline more than the broader indexes when volatility hits.
For example, in March, the S&P 500 dropped around 30% from its highs while the Russell 2000 Index fell almost 50% more during the same period (45%).
The ProShares Ultra Short Russell 2000 ETF (NYSEArca: SRTY) provides a 2:1 inverse return to the small-cap Russell 2000 Index. In other words, the SRTY shares go up roughly 2% for every 1% that the IWM declines.
Now, when you combine that with the fact that the IWM tends to sell off faster than the S&P 500 – remember that 45% decline in March compared to 30% in the S&P 500 – you've got the makings for a fast and aggressive hedge that can provide profits quickly.
Here's the way I'm playing the "Get Shorty" hedge…
Buy the ProShares Ultra Short Russell 2000 ETF (NYSEArca: SRTY) for $8.50 or less. Use a profit target of $15 for your exit.
Trade No. 3: Hedge Your Portfolio with an Option
Options are the perfect tool for hedging market volatility – sometimes literally.
Option on the CBOE Volatility Index (VIX) allow you to get in a position for profits when volatility starts to hit extremes, just like we're expecting to see in September.
The CBOE Volatility Index tends to "spike" higher when sellers take control of the market, which means that using an options on the VIX as a hedge requires a little more attention to the intraday activity.
That attention can pay off in a big way though, seeing as how my Night Trader subscribers have been able to turn the spike in volatility into large profits more than a few times over the last year.
To put things into perspective, the VIX spiked more than 400% in March while the S&P 500 dropped around 30%. A hedge against that 400% pop in volatility paid off handsomely!
The VIX shot up to readings around 25 on Thursday, but my 30 years of investing have taught me that "the VIX always spikes twice."
I'm expecting the Fear Gauge to pull back a little over the Labor Day holiday before taking another run at readings that will be in the 40-50 range. That's where you can profit with the following recommendation…
Buy to open the Nov. 18, 2020 CBOE Volatility Index ($VIX) $30 call for $7 or less.
Yes, this call option is priced lower than the market right now. That's because I'm expecting a double-top in the Fear Gauge, which means we'll be buying this volatility hedge as it does a quick pullback before spiking again.
And in the meantime, make sure to check out my latest presentation…
You see, I've had a better than 83% win rate on closed trades I've recommended since March 27 with an average profit per trade of 41% in six days. And folks, that includes the losing trades.
And if you kept that up for just 12 more days… you could have turned $475 into more than $1,300. Up the ante – and a $2,500 grubstake could have transformed into $39,000 – or more. Today, I'm letting you in on exactly how it's done…
About the Author
Chris Johnson is a highly regarded equity and options analyst who has spent much of his nearly 30-year market career designing and interpreting complex models to help investment firms transform millions of data points into impressive gains for clients.
At heart Chris is a quant - like the "rocket scientists" of investing - with a specialty in applying advanced mathematics like stochastic calculus, linear algebra, differential equations, and statistics to Wall Street's data-rich environment.
He began building his proprietary models in 1998, analyzing about 2,000 records per day. Today, that database, which Chris designed and coded from scratch, analyzes a staggering 700,000 records per day. It's the secret behind his track record.
Chris holds degrees in finance, statistics, and accounting. He worked as a licensed broker for 11 years before taking on the role of Director of Quantitative Analysis at a big-name equity and options research firm for eight years. He recently served as Director of Research of a Cleveland-based investment firm responsible for hundreds of millions in AUM. He is also the Founder/CIO of ETF Advisory Research Partners since 2007, noted for its groundbreaking work in Behavioral Valuation systems. Their research is widely read by leaders in the RIA business.
Chris is ranked in the top 99.3% of financial bloggers and top 98.6% of overall experts by TipRanks, the track record registry of financial analysts dating back to January 2009.
He is a frequent commentator on financial markets for CNBC, Fox, Bloomberg TV, and CBS Radio and has been featured in Barron's, USA Today, Newsweek, and The Wall Street Journal, and numerous books.
Today, Chris is the editor of Night Trader and Strikepoint Trader and contributes to Money Morning as the Quant Analysis Specialist.