Trading Strategy: Options trading of volatility

For the inexperienced trader, volatility is a synonym for “fear”. For the experienced investor, it is, above all, an essential mathematical figure that should be taken into account in trade decisions and often creates the best chances to profit in the market.

In this article, we explain how you can use volatility as a friend and trade it profitably.

What is volatility in trading?

In this context, implied volatility is the expected fluctuation intensity of stock prices or the extent of price changes. Whether it is a stock, an index, your house or a litre of gasoline, volatility is everywhere. For example, if at one petrol station a litre of petrol costs 1.20 US dollars one day, 1.21 US dollars the next day and 1.19 US dollars the next day, and at another petrol station the litre of petrol fluctuates between $1.17 and $1.23 over these three days, the litre of petrol at the 2nd petrol station is more volatile than at the first. The same applies to two shares or other assets. A stock with strongly varying price fluctuations is more volatile than a share with smaller swings.

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The volatility is expressed as a percentage to ensure comparability between two stocks. A stock that costs $10 and moves up and down by $1 will fluctuate by 10%, while a share that costs $1,000 and moves up and down by $1 will fluctuate by only 0.1%. Although both shares move around $1, the $10 share is much more volatile.

So volatility is not particularly difficult to understand: It is merely a metric that indicates the change in the price of a stock or any underlying asset.

For options traders, understanding volatility is the key to success. When all other parameters are equal, the value of an option is higher when volatility is higher and lower when volatility is lower. This can help investors choose the right options trading strategy. For example, credit spreads and short options are appropriate when volatility is high, and debit spreads and purchased options are suitable when volatility is lower.

The volatility of a stock can be determined “backwards” (historical volatility) if past stock prices are used to calculate the price swings. The volatility of a stock may be forward-looking (implied volatility) when option prices are used to estimate how much this stock may move up or down in the future. In options trading, we are typically only interested in implied volatility.

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The VIX Index

The “CBOE Volatility Index” (VIX) is one of the most popular and well-known measures of volatility. The index is used as a metric for the volatility of the entire market. The VIX is calculated from the option prices of the S&P 500 Index (US Ticker: SPX). Options with an average life of 30 days are included in the calculation. In essence, the VIX is an average of prices of SPX calls and puts.

When prices for SPX options are pushed up and down due to trading activity and market expectations of potential price changes in the SPX, the VIX moves accordingly. It is, therefore, the options on the S&P 500 that determine the VIX.

However, the VIX Index itself cannot be traded directly. With options on the VIX or derivatives of the VIX, you can still trade the volatility without any problems though.

The VVIX

Just as the S&P 500 has a volatility value that is measured by the VIX, the VIX itself also has volatility, because the VIX also fluctuates! The volatility of the VIX is measured by the VVIX: The “VIX of the VIX”. The value of the VVIX can help a trader to determine his options trading strategy on the VIX, just as the VIX can be a decision aid for an option strategy on the S&P 500.

Trading Volatility with ETFs and ETNs

There are mainly 3 ETFs and ETNs, which reflect the short-term course of the VIX, albeit not quite accurately:

> The UVXY: Leveraged ETF (ProShares Ultra VIX Short-Term Futures ETF). An investment in the UVXY aims to achieve a daily return equivalent to 1.5 times the performance of the VIX Index for a single day.

> The VXX: Unleveraged ETN (iPath Series B S&P 500 VIX Short-Term Futures ETN). ETN stands for “Exchange-Traded Note”. An investment in the VXX aims at a daily return that corresponds to the simple performance of the VIX Index for a single day. Of all volatility underlyings, the VXX is the one that comes closest to the performance of the VIX.

> The SVXY: An ETF (ProShares Short VIX Short-Term Futures ETF) that focuses on falling volatility. An investment in the SVXY aims at a daily return equal to half of the inverse performance of the VIX index for a single day. So if the VIX rises, the SVXY falls, and vice versa.

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These three underlying ETFs/ETNs cannot be traded directly by private investors due to European regulations. However, the detour with options allows you to speculate on these values with sophisticated strategies.

Options trading strategies for the VXX

The VXX, the UVXY, and the SVXY are well tradable with options. You can find opportunities on these underlyings with expiration dates every Friday. The VXX has the most significant daily option trading volume: Around 400,000 VXX options change hands every day on average, compared with 110,000 UVXY options and just 9,000 SVXY options. The trading volume is essential, because the higher the volume, the better the options can be traded and the better the spread between the bid and ask price.

Due to its unique mathematical construction, which is dependent on the so-called forward curve of the VIX, the VXX tends to be caught in a permanent downward trend. However, in times of high volatility and when the markets are falling sharply, the VXX can exhibit explosive price jumps. For example, during the coronavirus crisis, the VXX rose by around 460% between 20 February 2020 and 18 March 2020! However, these price jumps are generally of a short-term nature, and the VXX resumes its downward trend relatively quickly, even in the most challenging stock market periods.

An investor who places bets on a falling VXX with an appropriate investment size and with a limited risk strategy can be rewarded handsomely. But he must be able to ride out sporadic price jumps without having his portfolio erased. Ideally, he should wait patiently for the VXX to make such an extreme price jump before entering a position.

Strategy 1: The purchase of a simple putt

Let us assume that an investor wants to sell 100 VXX short to profit from a falling VXX. Let us also assume that the VXX is quoted at $50. The potential loss if the investor is wrong and the VXX rises would theoretically be unlimited. For example, if the VXX doubled to $100, the investor would suffer a loss of 100 x ($100 – $50) = $5,000.

If the trader instead buys a simple put that is deep in the money, e.g. with a strike price of $65 and a term of 3 months, he would pay around $2,700 (the put would have to be traded at $2.70 and with a contract size of 100 costs $2,700). This amount would also be the maximum risk of loss. Such a put would increase in price by about $0.70 for every dollar by which the VXX becomes cheaper. In technical jargon, one speaks of a put with a “delta” of 0.70. So if the VXX falls relatively quickly from $40 to $35, the put can become more expensive by $5 x 0.70 = $3.5. This corresponds to a profit of 350$ per contract.

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If the VXX remains constant or rises over 3 months, the maximum loss of $2,700 is imminent, but as already mentioned, it is limited to this amount. An investor must, therefore, be certain in his assumption that the VXX will initiate or continue its downward trend.

The deeper the put is in the money, the more accurately it reflects the performance of the VXX. However, the more expensive the put is.

Strategy 2: Buying a Bear Call Spread

Bear call spreads are combinations of 2 options: A buy and a short call. The buy call protects the position against a rising VXX. The short call benefits from a falling VXX.

The advantages of a Bear Call Spread over a simple put are many and varied. Depending on the choice of underlying prices, the maximum risk of loss is much smaller than with the put. Further, the VXX does not necessarily have to fall to achieve the maximum profit. It is sufficient for it to move sideways or even rise slightly (up to the strike price of the sold call).

The course of time is also on the side of the investor. The decline in the time value of the options unfolds the profit potential of the Bear Call spread day by day. For example, at a VXX price of $40, a bear call spread with a sold call with strike price $45 and a purchased call with strike price $50, both with the same 5-week maturity, would yield a gain of approximately $100. The maximum loss would be limited to $400. The yield of the trade is accordingly 100$ / 400$ = 25% in 5 weeks. The VXX may rise to $45 without this profit being reduced.

Conclusion

Experienced options traders know about the profit potential of VIX and its derivatives VXX, UVXY and SVXY. It is crucial to understand how these products work in order not to miss a potential profit opportunity on the one hand and not to take inappropriate risks on the other. 

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