Use the Volatility Index to Buy Insurance for Your Portfolio

The CBOE Volatility Index (VIX) is sometimes referred to as the fear index because it tends to move higher during times of fear and panic on Wall Street. I think a better term is the insurance index. Your insurance price is at its highest right after you've been in an accident. But there are some things that can be extrapolated from the VIX. The most important question is how is it moving relative to the S&P 500 ? Right now, the two look quite simpatico. S&P is rallying, slowly, and the VIX tanked during that incredible February recovery.Mark Sebastian's analysis was featured on Jim Cramer's "Off the Charts" segment on "Mad Money" March 3. Sebastian is a regular contributor to TheStreet's Options Profits. Has the VIX been lower than it is now? Yes, but not much. Calling bottoms in the VIX is about as smart as calling tops in the S&P 500. At this point, the VIX is low, in relative terms. So if the price of the VIX is the cost of investment insurance, we are being given the opportunity to buy portfolio protection at very attractive levels. Some investors feel it's time to go to cash. I do not think that is the best option. The biggest fear now regards how Federal Reserve monetary policy might affect the S&P 500, but look at how the market has performed since the Fed began tapering its quantitative easing program. Is a dip to break even worth giving up a year of returns in the double digits? With the VIX around 13, one can buy portfolio insurance that might amount to only a few hundred basis points, a small price to pay to prepare for the time when market fear ahead of a Fed meeting finally proves itself right. The time to be complacent and unhedged is over. In general, the VIX rises when put-option buying increases, and it falls when call-buying activity is more robust. With the S&P 500 nearing all-time highs and the VIX lower, now is the time to take advantage of cheaper insurance. Should the market pull back, put premiums will get more expensive as demand increases. Just like with any insurance, you don't wait for an event to happen and then get forced to pay up. Buying portfolio protection in the form of SPX puts does not imply a directionally bearish posture, but rather a prudent hedge to protect gains and longer-term positions.

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