The Perfect VIX Trade?

A couple months back I wrote about University of Phoenix parent company Apollo Group (NASD: APOL) and student-loan lender Sallie Mae (NASD: SLM), in a piece entitled Shouldn’t It be the Other Way Around?

I began with an open admission that the chart – showing Apollo Group’s fall and Sallie Mae’s rise – absolutely baffled me.

My initial premise was simple: Sallie Mae, the entity “holding the bag” of potentially worthless student loans, should be faltering as investors grow increasingly concernrned about default rates and the sheer size of the student loan bubble.

Meanwhile, I expected better performance from Apollo Group, which appeared to benefit from the governrnment-originated loans Sallie Mae deals in (not to mention a weak job market), while shouldering none of the risk related to defaults.

The piece was well-read and generated a lot of feedback from subscribers, who wrote in with their own theories. Thank you.

Since then I’ve continued to mull over yours and other theories related to the student loan bubble, and wonder who will emerge as the winners and losers.

In doing so, I stumbled across a relationship that could be very valuable should we experience another financial meltdown, as we saw between late 2007 and early 2009.

Calculating a ratio of the stock prices of Apollo Group and Sallie Mae (APOL/SLM) produces the white line below. Meanwhile, I’ve shown the VIX – a common measure of volatility – in blue. Take a look…

See larger image

I think this relationship is stunning!

Not only does the APOL/SLM ratio correlate highly with the VIX, it does so on a slight lag. This was first evident at the beginning of 2007, when the VIX began climbing. The APOL/SLM ratio began rising by mid-year.

And naturally, the most profitable move that traders could get – when the VIX shot from 20 to 90 in less than two months – came right around 2009. The VIX peaked first, in late 2008. Then on a lag, the APOL/SLM ratio peaked in early 2009.

The point is, if this relationship holds up moving forward, sudden spikes in the VIX could provide a very early signal – several months in advance – that the APOL/SLM ratio will eventually spike higher as well.

Knowing this, investors looking to hedge against the possibility of another blow to long-stock portfolios could trade the APOL/SLM spread. The trade to make would be equally dollar amounts of:

1) Long APOL stock, and
2) Short SLM stock.

Armchair philosophers (myself included) can continue to wonder about the driving forces behind these stocks and their performance during financial crises. And traders and investors alike (myself included) can also use history as a guide, using the APOL/SLM spread as a tool to rake in profits during the next financial crisis.

Adam O’Dell

Using his perfect blend of technical and fundamental analysis, Adam uncovers investment opportunities that return the maximum profit with minimum risk.