The days of sub-10 VIX may be gone for the foreseeable future, but that doesn’t mean traders have stopped betting against higher volatility. In fact, the short volatility trade seems like it may be returning with a vengeance.
Well, let me step back a bit. The short volatility trade may be returning on the professional level. Retail traders still appear to be wary of selling volatility – and with good reason. It was the retail crowd that mostly got hurt on February 5th and the aftermath back when XIV, a popular inverse volatility ETN, imploded.
Access to short volatility isn’t quite as easy as it used to be, and I imagine there are plenty of gun-shy retail investors who got burned back in February. Nevertheless, making money on short volatility can be a great way to increase yield and trading returns. Moreover, the big money may be stepping in now and selling volatility in chunks.
XIV, which was basically the inverse of iPath S&P 500 Short-Term Futures ETN (NYSE: VXX), is now out of the picture. ProShares Short VIX Short-Term Futures ETF (NYSE: SVXY) has been redesigned to provide only 50% short exposure to front month VIX futures. As such, it has fallen on VXX and VIX futures options themselves to carry the lion’s share of the volume of volatility trades.
VXX only has exposure to the first two VIX futures months, while any VIX month with a future can be traded using futures options. For the most part, VXX has maintained strong volume since the February 5th volatility event, trading about 44 million shares a day on average over the last 90 days, while options have traded a brisk 363,000 average per day over the same period.
Now, it’s easy enough to take a short position on volatility by purchasing puts on VXX. Of course, puts make money when VXX goes down, and VXX goes down when volatility retreats. That’s a perfectly reasonable strategy. But keep in mind, buying puts does come with time decay risk. Long options are always decaying as they approach expiration, so you do have a timing variable that comes into play.
On the other hand, selling calls on VXX means time is on your side. Being short calls also benefit from VXX going down (or sitting still). But, being short options means you collect time decay rather than pay it. The risk is if VXX spikes higher, your losses can be staggering.
One way to protect yourself against a spike in VIX but also get the benefits of time decay is by selling a call spread instead of selling naked calls. Selling a call spread (selling a call closer to the stock price, while purchasing a farther out call) lowers your premium collected, but caps your losses.
Take for example, this very large trade that occurred in VXX earlier this week. A trader sold the June 8th 37-43.5 call spread for $0.59 with VXX trading at $34. Selling the call spread means the trader sold the 37 calls and bought the 43.5 calls. The spread was executed over 6,200 times meaning the trader collected over $367,000 in premiums.
If VXX closes under $37 in the next 17 days, the trader keeps the entire premium collected. On the other hand, if VXX spikes above $43.50, the trader is at risk of losing $5.91 ($6.50 spread gap minus the $0.59 premium collected).
It may seem like $0.59 isn’t a lot to collect versus a max loss of $5.91. However, the trade only lasts for 17 days. Moreover, with the China tariff situation seemingly resolved for the time being, there aren’t a lot of potential volatility catalysts on the horizon.
Still, while I like the idea of selling a call spread, I’d probably go a bit higher out of the money and go farther out in time to compensate. For instance, the June 29th 39-44 call spread would result in around $0.70 in premium versus a max loss of $4.30. You have to wait a few more weeks until expiration, but it would take a pretty major event at this point to push VXX to $40 or above. To me, that’s a reasonable trade off to make.
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