Many Weapons in Volatility Trading

Includes: LM, VXX, VXZ
by: optionMONSTER

By Chris McKhann

Someone asked me recently how I go about trading volatility, so I thought it would be worthwhile to discuss various methods here. Volatility trading is taking off, both in terms of volume and trading vehicles, but choosing your strategy is the key to getting it right.

Options volume set a new record in May, the first time we had more than 400 million contracts trade in a month. May 6, the day of the "flash crash," set a new volume record with 30.8 million options traded. The CFE CBOE Futures Exchange also saw record volume, with more than 480,000 contracts traded, up almost 10 times from May 2009.

New products continue to roll out that allow retail traders to trade volatility. VIX futures have been in play for six years and VIX options for more than four, but now the Short-Term VIX Futures (NYSEARCA:VXX) and Medium-Term VIX Futures (NYSEARCA:VXZ) exchange traded notes have been increasingly popular since their release in early 2009. And as of last week there are now options on those ETNs.

The idea of volatility trading is appealing to many. Volatility is mean-reverting, which means that it will return to the average at some point after extreme moves. Volatility also tends to increase when stocks fall, making it an interesting and truly non-correlated, hedge. The implied volatility of many indexes also tends to be overinflated because of protective put buying.
LM Chart

So there are a number of ways of trading volatility. Buying calls is getting long volatility, as is buying protective puts. Covered calls and short puts are volatility-selling strategies. Short straddles and strangles are one of the more advanced and risky ways of selling volatility.

We saw just such a strategy in Legg Mason (NYSE:LM) on June 2. A trader sold 20,000 of the July 32 calls and July 27 puts, taking in a total credit of $2.30.

This trade was based on the idea that LM would stay in the range between $27 and $32. It was also a clear statement that the implied volatility of those options was too high, at 45 percent for the calls and 56 percent for the puts. At the time, the 30-day historical volatility was up at 60 percent, up from 25 percent two months earlier and the highest level in 10 months.

One of the big issues with this type of volatility selling is that it depends on two things: The first is the actual fall in volatility, and the second is LM staying between $27 and $32. These may sound like the same thing, but they are not.

For instance, shares of LM climbed from $25 to $33 from February to mid-April, and broke above $32 on Friday, as indicated by the updated chart above. That is a 32 percent climb at the same time that the implied and historical volatility fell 25 percent.

This latter issue is one of the big problems with using options strategies to sell volatility and it is known as "path-dependency." Products such as the VIX options and futures and the VXX can be complicated, but they remove the problems of path-dependency and offer pure exposure to volatility.

One of the problems is that all VIX products are based off of the VIX futures. And when the VIX spikes higher, the futures typically lag. So selling VIX futures or the VXX or buying puts on the VXX or VIX is betting on a mean reversion in the VIX, which is already partially priced into the futures.

Therefore, if you think that the VIX is going to come down and that the S&P 500 is going to rise, you should sell SPX puts, as that is real exposure to the VIX. But if you think that the VIX is too high but that the SPX might continue to grind lower -- exactly what we saw going into March 2009 -- then using volatility products makes much more sense.

Disclosure: No positions