How To Buy Protection And Get Paid For It

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Includes: AAPL, QQQ, SPY, VXX
by: SteadyOptions

In one of my previous articles, I described a few ways to protect your portfolio against an inevitable correction. You could use the SPDR S&P 500 ETF (NYSEARCA:SPY) puts to structure few different trades, depending on your market outlook.

Since that article, the markets added a few more percents to their incredible run. Apple (NASDAQ:AAPL) contributed a major part to the current run. The stock is up 20% in the last three weeks alone.

I described here why I think Apple is going to correct and how you can play it. The stock accounts for 15% of the Nasdaq-100 ETF PowerShares (NASDAQ:QQQ) due to its huge market capitalization. It is clear that when Apple corrects, it will take the Nasdaq and the rest of the market down as well.

Both Apple and the general markets have been defying any logic as the charts "go parabolic." It's only matter of time till they correct. In this article I'm going to show a way to play the general market correction using some of the Volatility products.

The VIX, created by the Chicago Board Options Exchange in 1993, is the Volatility Index. VIX was originally constructed using the S&P 100 index, but in 2004 CBOE switched to the S&P 500 to capture a broader segment of the overall market.

The VIX was designed to measure expectations for volatility. The VIX has a significant inverse correlation to the price action in the S&P 500. The inverse correlation would make the VIX an excellent hedge for traders and investors. The problem is that VIX itself is not a tradable vehicle. To overcome this problem, you can trade VIX options.

Here is one possible trade using VIX options (VIX is currently trading at $17.78):

  • Sell 10 VIX Apr 17 Call
  • Buy 20 VIX Apr 25 Call

This trade is called a Call Backspread. It involves being long OTM (Out of the Money) call options and selling ITM (In the Money) call options at a ratio, generally buying 2 OTM calls for each ITM call. The trade can be done for $0.60 credit plus $8.00 per spread margin requirement. For 10 spreads, you get a $600 credit. You should use this strategy if you expect a quick and sharp upward move in the underlying. Increasing IV (Implied Volatility) will increase the gains as well.

This trade will be a nice winner if there is a quick and sharp meltdown in the markets causing a sharp increase in VIX. The P/L graph looks like this ():

The white line represents the P/L today and the red line the P/L at expiration. However, we are not going to wait until expiration. The timeframe for this trade is 4-5 weeks. If the correction doesn't materialize during this timeframe, the trade should be closed.

The biggest issue with this trade is the fact that it is theta negative. If VIX stays around the current levels, it will start slowly losing money. To overcome this problem, we can use weekly options on the The iPath S&P 500 VIX Short-Term Futures (NYSEARCA:VXX). The VXX maintains a rolling long position in the first and second month VIX futures contracts.

The following trade idea belongs to my fellow SA contributor Erick McKitterick (check out his articles, you will really enjoy them). He suggested buying weekly call Ratio Spread on VXX. With VXX currently trading at $26.20, you could do the following trade:

  • Buy 10 VXX Feb. Week4 29 Call
  • Sell 20 VXX Feb. Week4 30 Call

The trade can be done for $0.15 credit plus margin requirements. For ten spreads, you are getting $150 credit.

So let's see what could happen if you made those two trades with 10 contacts.

  1. If VIX continues trading around the current levels or drifts lower for the next 4-5 weeks, the VIX trade will stay around the current levels or lose around $50-100 due to negative theta. However, the VXX calls will expire worthless gaining $150. You can repeat the VXX trade every week using weekly calls approximately 10% Out Of The Money (OTM).
  2. If VIX drifts higher, the VIX trade will stay around breakeven but VXX trade might gain more than $150. For example, if VXX ends the week at $30, the VXX trade makes $1,150.
  3. If VIX makes a very large move, VXX will follow. If VXX jumps above $31.15, the VXX trade will start losing money. However, the VIX gains should far outpace the VXX losses. For example, if VIX jumps to $25, the VIX trade will make around $2,300. At the same time, VXX trade will be only a small loser. Since VIX is usually rising much faster than VXX, VIX will continue making more money than VXX is losing.

According to Bill Luby from VIX And More:

"In Greek mythology a Minotaur was a hybrid creature with the body of a man and the head of a bull. Such a creature provided the inspiration for a pairs trade involving short VXX at-the-money calls and long VIX at-the-money calls."

The pairs trade presented in this article might be a promising variation of Bill's "VIX-VXX Minotaur trade". I would appreciate any feedback about the trade.

If you decide to follow this trade, please make sure you understand exactly what you are doing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.