Take a punt on the return of fear

The markets are recovering; the FTSE 100 is back to where it was in September 2008. Calm has descended, normal service has been resumed.

But in this financial environment something's bound to blow up again. Who knows whether it's going to be another banking crisis, sovereign debt, or simply a continuation of the recession. Frankly, it doesn't matter, but this calm isn't going to last forever.

Now is the right time to place your bets on the return of market volatility. Insurance premiums are way down as investors fears have evidently faded away.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Let me explain a trade that should make serious money if the markets turn down again

The markets are back to normal

Investors aren't expecting any dramatic movements in the markets. How do we know this? Because the Vix index tells us so.

The Vix index, known as the 'fear gauge' measures market volatility. It's a rather ingenious American invention; it measures the anticipated volatility on the S&P 500, and tells us the likelihood of the market swinging up or down over the next month. When the markets are volatile, it gives a high reading; when the markets are calm, the reading is low. Right now, the Vix is trading at the bottom of its two-year range.

Although the Vix forecasts upward and downward swings, in reality, the Vix is much more sensitive to market falls than rises, hence the nick-name 'fear gauge'. So from our perspective, it's a great hedge against a fall in the stock market.

Here's the two year chart:

Because the Vix is low, the market is telling us that we're back to normal, or at least as normal as it was back in the summer of 2008. It's currently trading at 19; amazingly, that is below its long-run average of 21. This tells me that investors are being far too complacent. Call me a Cassandra if you will, but the economic realities hardly point to normality.

When the market lurches downwards, the Vix lurches upwards. During the dotcom bust and the Asian crisis, for instance, the Vix went to 45 and 46 respectively. During the financial crisis, the Vix topped out at about 80. There's no guarantee that the banking crisis is even over and there's certainly no guarantee that we're safely out of recession.

Gold, the other classic fear gauge, is trading near its all-time highs, telling us that at least some investors are very fearful at the moment. So why on earth is the Vix suggesting that fear has practically evaporated? They can't both be right!

The great thing is that you can take advantage of this anomaly. If, like me (and the gold market for that matter), you think that volatility will be back, then there is a way that you can profit when jitters return.

How to profit from volatility

The Vix is now down to 19. A market wobble could well see it bounce back to 25, or 30. In extremis even 80, but let's not go there. again!

There are a couple of ways to trade this. If you want to buy a stock that mimics the Vix, you can buy Barclays i-path VIX traded in New York and Frankfurt. But for me, the simplest way is to use a spread bet.

Spread bets sound complicated, but really, the idea is quite simple. To take the Vix example, this is what you would see quoted by a spread-betting company:

March quote 19.1 - 19.3

This means that you can buy the Vix at 19.3, or sell it at 19.1

Now, if you buy at £100 per point at 19.3, you will profit £100 for every full point the index moves upwards. So if it goes to 24.3, you'll profit £500 (£100 x 5 points).

The bet is based on the Vix, which is quoted in the US. This means that the market is open between 2.30pm until 9pm GMT. As the spread betters desks are open 24/7 this doesn't make any real difference to us.

Spread betting may sound risky, and it can be, but it's really only a tool. Like any tool, it's the way that you use it that determines how dangerous it is.

In this case what we're doing is betting that market volatility will come back. Or to look at it another way, we're buying insurance against the risk of a market fall.

In terms of your overall portfolio, you're actually reducing risk. It's nice to know that at least one position will go up even if the rest of your portfolio falls.

IG Index and City Index both offer bets on the Vix. But you can compare the top 20 spread betting accounts on MoneyWeek's comparision tables.

Now is the time to buy insurance. Markets are calm, so the premium is cheap.

I would buy anywhere below 21. Set a stop loss 5 points below your opening position. This means that if the bet moves against you, the most you can lose is 5 points. So, if you open at 20 with £100 per point, your bet will be shut out if the Vix reaches 15. You will have lost £500 (£100 x 5).

Find out more about how spread betting works here.

This article was written by Bengt Saelensminde and was first published in the free investment email The Right Side . on 12 March 2010.

Your capital is at risk when you invest in shares – you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment.

Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Margin amounts vary between spread betting companies and the type of markets spread bet.

Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Theo Casey. The Right Side is issued by Fleet Street Publications Ltd. Fleet Street Publications is authorised and regulated by the Financial Services Authority. FSA No 115234. https://www.fsa.gov.uk/register/home.do