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Did the S&P Bottom Thursday? Yes, Says the VIX

Brian Stutland | President, Stutland Equities and CNBC Contributor
Friday, 9 Nov 2012 | 11:35 AM ET

On Thursday, the S&P 500 sold off over 1 percent, and the CBOE Volatility Index also sold off over 4 percent.

This is unusual, because typically, a 1 percent down move in the S&P 500 would translate into a 4 percent rise in the VIX . (Read More: Not a Pretty Market Close—Here's Why.)

So what can we make of Thursday's action? Actually, the move in the VIX was a bullish indicator.

The VIX is often called the "fear index," but let's remember what the Volatility Index is actually calculated from: the prices of S&P 500 index options. The reason that the VIX tends to move up when the S&P falls is that when the market is having a bad day, traders tend to bid up the cost of out-of-the-money puts in order to protect their portfolios from further declines. Since the VIX measures the prices of these options, this buying pushes the VIX higher.

On Thursday, however, traders did the opposite. They were selling puts, or selling insurance, at levels at which they were willing to buy into the market.

In an example of the kind of action that drove the VIX lower, let's look at the biggest trade of the day in SPDR S&P 500 ETF options. That would be the sale of 48,000 November 136-strike puts for $0.53 each, which was done with SPY at $138.75.

This trade will profit as long as SPY is above $135.47 at November expiration, which is in eight days. If SPY is lower than $136, then the trader will have to buy 4.8 million shares of SPY at $136, even if it is trading well below that level. This trade implies a bet that the SPY will stay above $135.47 through November expiration — and/or the conviction that below $136, the SPY is a buy.

(Read More: Why US Economy May Be Headed for Another Recession.)

For people who want to begin buying into this market, selling puts is a good way to go, because you can effectively get paid to lock in a price at which you are willing to get long. However, selling puts means that you have all the downside of a long stock position, so you must be comfortable with the risk of having to buy the stock if it falls below the strike price.

For people trying to pick a bottom in the S&P 500, but who don't want to take delivery of the stock, I recommend turning this trade into a put spread by buying a deep-out-of-the-money put as a hedge. This will cut your losses if the market takes a deep dive.

And let me disclose: Personally, I have a bull SPY put spread on now.

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

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