Options Trading: Playing The New Volatility Regime

| February 14, 2018 | 0 Comments

volatilityWhether the stock market correction is over, or if the recent correction signaled the end of a bull market is debatable and will only be determined over time. For options trading, we’re going to have to hedge our bets a little.

One thing that does seem to have come to end was the extended period of historically low volatility.  The records, such longest streak without a 5% decline and the most readings of the VIX under 10 in a single year, are well-documented.

The recent surge in the VIX, and resulting implosion of short volatility ETNs,  suggests that we will be entering a higher volatility regime in the coming months.  I’m not saying volatility will continue to be insanely high, just it won’t sink back to those obscene lows of 2017.

More importantly, people will once again look to buy or get long volatility as a hedge, rather than sell it as a means to collect premium or produce yield.  And that in itself will keep a bid or higher baseline in the VIX and the related products.

Indeed, many top hedge funds such as Bridgewater seem set to shift gears, as they are predicting a new era of volatility due to the unwinding of Central Bank balance sheets which will lead to higher interest rates and less liquidity.

Then again, some money managers, such as Eric Peters of One River Assets sees two possible scenarios. In one, the recent spike in volatility subsides relatively quickly and then leads to a renewed leg higher for stocks. He describes this situation like this:

“This VIX ETF/ETN spark ignites other structural volatility shorts over the coming days/weeks, driven by a critical mass of risk managers across the financial industry not wanting to be the last to de-risk. Selling of risk assets increases volatility and this sparks more selling of risk assets in a reflexive way. In this scenario, visions of the ETF/ETN blowup makes value investors more patient in buying the dip. And with a new Fed governor, you don’t get a swift response. It’s bombs away for risk asset prices.”

Here’s the positive feedback loop that could develop.

positive feedback loop

Options Trading: VXX Ratio Spread

This environment of slightly elevated, but not bear market or panic level, volatility sets us up for a very attractive trade in the S&P 500 Volatility ETF (VXX).

The options trading strategy I want to use is called a ratio call spread, which consists of buying in-the-money calls and selling a greater number of out-of-the-money calls with the same expiration date.

The sale of the OTM calls helps finance the purchase of the ITM calls.  The goal is create a position for a very low debit (or even receiving a credit) and the ratio of calls sold to those purchased as much as possible to minimize the number a net ‘naked’ contracts.

This options trading will take advantage of the value of the VXX remaining steady to moderately higher, but the implied volatility of the options declining.

As you can see, the implied volatility of the VXX options, essentially a derivative of the derivative, has shot up dramatically.  I would expect it to revert to a more normal level in coming weeks.  The ratio call spread benefits from the normalization of implied volatility.VXX daily 1 year volatility chart

With the VXX currently trading around $48, the specific trade I’m looking at would be:

Buy the March 46 calls and sell twice as many March 60 calls for a bout a $0.30 net debit.

A 5×10 contract position, such as the order ticket below shows, would cost a net debit of $1.50.

VXX Order Entry Ticket

But the margin, and therefore risk, could be much higher due to the “naked” aspect of the position.  In this case, we are net short 5 contracts.

As the risk profile shows, while the profit potential is great, there is also tail risk of a big loss should volatility surge yet again in coming weeks.

VXX Snapshot Analysis

Another surge in volatility is entirely possible, but from current levels it seems highly unlikely.

Indeed, the only time we’ve seen higher levels for any sustained period was during the financial crisis.  And whatever re-setting the market is experiencing right now I don’t think it will turn into an economic crisis or market meltdown.

That makes a VXX ratio call spread a great way to profit from this shift higher in volatility levels.

 

Note: This article originally appeared at Option Sensei on February 12, 2018.

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Category: Options Volatility Watch

About the Author ()

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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