The month of October will go down as a surprise and shock to many investors. We at theOptionsEdge.Com are always a bit skeptical on extended bull moves and whenever it looks like the popular averages are going to roll over, we suggest investors hedge their books by either selling call spreads (a soft hedge) or buying put spreads (a harder hedge) on one of the broad market indexes like the Dow Jones Industrial Average, S&P500 or the Russell 2000.
Since we are retail investors her at TOE, we trade options on ETFs. Institutional investors often use index options to do the same thing. Any observer of the markets knows that realized and implied volatility tends to rise when equity prices fall. There are a number of good reasons for this. But at the heart of the matter, it is because fear is a more powerful emotion than greed. People will go to greater lengths to survive versus to simply thrive. As a result, prices tend to fall faster than they rise. When protecting their capital, traders tend to sell first and ask questions later.
At the same time, there is another class of investor who wants to protect the value of their portfolio. They typically want to hold on to the investments they have as they have built their portfolio one position at a time. These investors buy put options as a hedge against a general fall in market prices. As their fear rises, they are willing to pay more and more for that protection. This is phenomenon is reflected in the VIX, the Volatility Index. The VIX is a measure of the price of near the money, 30-day options on the S&P500. In the world of options analysis, people use implied volatility as a measure of price. They do because it normalized the price of an option for time to expiration, the price of the underlying and strike price of the option itself. As a result, it allows people to compare different options on the same footing. It also allows people to compare the price of options over time.
The chart above shows that the VIX is elevated to levels far above normal. The VIX is currently at 24.7% identified by the upper green dashed line. Notice that in the past 5 years, it has spent very little time above this level. When it has gone above the current price, it did not stay there long. That being the case, one might want to think about selling volatility. At these prices, it seems like volatility is more likely to fall than increase. Unfortunately, one cannot sell volatility in a straightforward way as it is not an asset. The VIX is a mathematical construct. But there are a few ways the retail investor can take a position.
One can “short” VIX synthetically by selling a VIX call and buying a VIX put. Many people use this approach to sell “vol”, but we have reservations about options on VIX, principally around uncertainty associated with expiration. VIX options are cash settled. Since the VIX options market is not as deep market like the S&P500, it is subject to manipulation at that instant in time when the options expire. We have talked about this during interviews with the Wall Street Journal.
An alternative is selling the ETF, VXX. VXX is an ETF that holds long positions in the 1st and 2nd front month of VIX Futures. Every day, the manager of VXX roll 1/30th of the portfolio from the 1st-month futures to the 2nd-month futures. As a result, it is able to keep the average maturity of the portfolio constant through time. It is important to understand that VXX behaves like an option. Its value typically decays over time. This happens because the VIX term structure is usually upward sloping. As time passes, the 2nd-month futures fall in price relative to the 1st-month futures. So the fund buys high and sells low. When the term structure is flat, there is not decay, and when the term structure is inverted, VXX drifts higher in price.
Since the term structure is upward sloping most of the time, institutional and retail investors often sell VXX short hoping to capitalize on the downward drift down in price. Given this phenomenon, there are some hedge funds out there that systematically sell VXX. This causes the securities to be expensive to borrow as owners of the security demand a fee from the fund that wants to borrow it. Currently, the VIX term structure is slightly inverted, so VXX is likely to simply increase or fall with the VIX index.
If one wanted to sell volatility, one way to do it is to sell a call spread on VXX. With VXX trading at 40.32, consider the following structure.
In this trade, the investor collects $93 up front, which they get to keep if VXX trades below $40 at expiration. If we assume a random walk, there is a 58% probability of this occurring. The most one can lose is $207 which would occur if the share price rises above $43 at expiration.
It is important to recognize that there is a market directionality in this trade. If the equity markets continue to sell off harshly than expect VIX and VXX to increase. If however, the market settles down, we should expect both VIX and VXX to fall in price. The following chart was drawn from the Bloomberg terminal that shows a linear regression between VXX and SPX (S&P500). Notice 2 things. (1) VXX and SPX are inversely correlated. (2) VXX is about 6.8 (1/0.147) times more volatility than SPX. Given this leverage, we suggest investors who pursue this idea, do so by taking a smaller position than they usually do.
So if the S&P 500 falls, we should expect VXX to rise in price and visa-versa. The intercept tells us what is likely to happen if there is no change in the S&P500. If this occurs, we should expect VXX to fall in price by $0.023 per day. Therefore selling a call spared on VXX has a bullish bias with some carry. If the S&P500 trades flat, this trade will make money. If the S&P500 rallies, this trade will make money. If equity prices continue to sell off harshly, this trade will lose money.
Given that we think the first leg of the selloff is coming to an end, we think the prospects of this trade are pretty good. Oh, and by the way, we chose a short time to expiration as the amount of additional premium one would collect by using longer dated options was negligible.
Image Source |Markus Spiske temporausch.com, Pexels.Com
Mark is long SPY with Options and Short VXX with Options
