VIX Options: 'Belts And Suspenders'

Includes: SPY, VIXM, VXX
by: Reel Ken

"A year from now you may wish you had started today."
Karen Lamb

Effective risk managers are well aware of the expression "Belts and Suspenders." Engineers may recognize it as "Redundant Systems." Either way, it refers to being "doubly safe" against risk.

Those that regularly read my articles are well aware of my concerns for portfolio protection. Maybe when the politicians become less obstructionist, government becomes more businesslike, the elections and "fiscal cliff" are behind us and geo-political issues abate, I'll ease off of my concerns. But for now, I stand fast.

As an addition to my regular strategies (the belts, if you will), I started selling puts against the VIX when it hit 15 (suspenders, if you will). It's a little over 16 now, so some of the advantage is past, but it is still low enough to continue as a strategy.

The VIX simply measures volatility. Now, volatility can be elevated when a market is down and on the way up or up and on the way down. It can also be low at bottoms and tops. As such, any particular level, all by itself, tells us little.

That said, each investor must make their own determination as to whether the market is more likely to rise or fall and whether the VIX is likely to presage or follow a trend. Here's how I see it. Let me start with a table showing the BID price of puts on the VIX, which is trading at 16.49 as I write this ...

Bid Prices for VIX Put Options

Strike Oct Nov March


.45 .30
16 .50 .90 .55
17 1.05 1.40 .90

Note that the October expiry is only a week away.

What we notice is that the bid prices actually decrease over time. If this were the case for a normal stock, you could arbitrage a gain using a calendar spread. But, the VIX reacts a little strangely at times and can actually show negative intrinsic value, so I'll stick to a put sale.

What I conclude from this table is that the "smart money" is betting on a rising VIX and so will I.

Let's look at the risk elements involved and try to quantify our risk in this trade.

1) With the S+P near all time highs and the VIX at relatively low levels (not as low at 16.49 as it was at 15), a drop in the S+P is more likely than a rise and the VIX is more likely to go up than down if it drops.

2) If the VIX doesn't go up, it probably correlates to a narrow trading range. Hey, I'm happy if this happens, especially since I sell a lot of near ATM puts and/or calls on the SPDR S+P 500 ETF (NYSEARCA:SPY) and others.

3) If the VIX falls, I may lose some money on this INITIAL trade, depending upon my strike and premium credit, but I'll just repeat selling puts on the VIX at the same strike. I know one thing for sure, the VIX will exceed 16.49 sometime and I'll show a cumulative profit or I will be a very happy camper with regards to my overall portfolio.

So, in this regard, I see selling puts on the VIX as a very simple form of portfolio protection.

What about expiry dates? Well, certainly with decreasing premiums, near term expiry is mandated. I'm 50-50 on the October versus the November expiry so I'm selling equal amounts of each.

What about Strike Prices? This isn't so simple, and really tests the courage of my convictions. I've decided to answer this by playing it a little safe. I'll sell the ATM strike at 16, but I'm going to be a little aggressive and sell enough to equate with 10% of my portfolio (some suggest 5% should be the top) as I feel strongly that the next few months will be volatile.

If the VIX stays around current levels at expiry, I'd repeat the put sale, but if the VIX rose, to, say 18 or above, I'd probably back off until it dropped.

Remember, I actually employed this strategy when the VIX was at 15, so I've booked profits already. But I feel that even with the VIX at 16.49, the premiums received justify going in, and I'd do it now, if I hadn't already employed this strategy.

Now, I'm sure lots of readers will "chime in" with ... buy/sell VXX, VIXM, options on VXX, VIXM, etc., as these seem to be favored trading tools. I will confess that options on these products may work better, but they have a lot of nuances, efficiency and tracking issues. Far too many for me to get my arms around, so I'm going with the simplicity of the VIX as I know it well. I'll leave the nuances to those with more trading skills than I possess.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I sell puts on the VIX and sell and buy puts/calls on SPY