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On Anniversary of 'Black Monday', Is It Time to Buy Protection?

Brian Stutland | President, Stutland Equities and CNBC Contributor
Friday, 19 Oct 2012 | 10:42 AM ET
AP

Friday marked the 25th anniversary of the 1987 market crash, a day when the S&P 500 fell over 20 percent and traders learned the importance of covering their tail risk.

Today it is as imperative as ever to cover your tail risk, and yesterday we saw one trader doing just that. With the January VIX futures trading at 19.20, one trader bought 11,000 Jan. 45 VIX calls for $0.30. (Read More: 'Black Monday - Could It Happen Again?)

These calls are 136 percent out of the money and to many, that premium the trader spent may seem like wasted money. However, should a black swan event occur between now and January, these calls will explode in value, as traders scramble to buy portfolio protection and implied volatility skyrockets.

There is no shortage of headlines that could come out of Europe, the Middle East, or the good old U.S.A. that could cause a massive sell-off, and that is why we are seeing so many traders hedging right now. At the same time, it only takes a glimpse at a chart of the S&P 500 over the past year to see that we are in a bull market. We want to be invested in the market right now, but also keep tight hedges on, in case the uptrend abruptly reverses. (Read More: Old Pros Recall 1987 Market Crash)

Buying deep-out-of-the-money VIX calls is one way to accomplish this, though it can be costly due to options decay, and they need to be rolled forward at expiration. However, it only takes one extremely volatile day to make this insurance pay for itself.

And as we remember that day in 1987, we recall that it was the traders with long volatility positions who has the last laugh — and more importantly, who were able to stay in the business to trade another day.

Brian Stutland is the President of Stutland Equities and a contributor to CNBC's "Options Action."

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