Youtube video: www.youtube.com/watch?v=4In2qaPCRHY
About a month ago, I wrote an article that suggested readers to go long volatility (hedged, of course). The trade of my choice was buying a strangle with strike price of $18 and $28 for the put and the call, respectively. It cost $2.98 per contract. Yesterday, VXX reached $30, and I sold the remaining chunks of my position, which yielded me some nice profits.
VXX has been trading in high 20s for over a month now. However, you should know that VXX is an instrument that trades withing certain boundaries, that is, it is mean-revertible. Although I put a vote up about 3 weeks ago in which I agreed that VXX is going to reach $35 by February 20, 2016, I really started doubting this proposition. VXX has showed me that it can stay high for long periods of time without going above the $30 mark. Besides, as the option chain shows, chances of going above $35 are ridiculously small - about 5%:
The video in the beginning of this article suggest that VXX is likely to start going down, at least in the short-term. The author recommends traders to buy inexpensive at-the-money puts to capitalize on this assumption. This may be a safer strategy than the one I would like to propose. What I would like to do is SELL long-term ATM calls (e.g. January 2017 with a strike of $29) and simultaneously buy short-term calls with a strike of, say, $35. There are two reasons why I structure the trade in the following way:
(1) Long-term calls and puts are expensive because of time value. Hence, if you sell those, you get a cash inflow, which you can use to buy OTM options for hedging purposes (you don't want to get potentially unlimited upside exposure and a short-seller, who you are in this case);
(2) Short-term OTM options are cheap. The point is, we do not really care where the options move in the long-term, as long as our net gain is above zero (including trading fees and taxes). However, we do care about short-term volatility as it can really eat into profits (the tame decay we are harvesting as sellers is not going to offset losses by a considerable amount).
Currently, I see the following prices for the options I am eyeing:
The above chart includes option prices for calls expiring on January 20, 2017
The above chart includes option prices for calls expiring on February 19, 2016
Readers can see how big the premiums are on the long-term ATM calls - over $8 per contract. In the same manner, short-term OTM calls are extremely cheap - about $0.12 per contract. Assuming that you can sell the calls at $8 per contract now and buy weekly OTM options at an average price close to the market price of the current OTM options for the next 49 weeks, you can realize a net credit position of $2.52 per contract (fees and taxes excluded). Of course, as time progresses, you will get a clearer picture about the probability of the index reaching a $35 mark. Sometimes, you may not fully hedge your short exposure (e.g. buy less contracts on OTM calls).
Your maximum loss with this strategy is about $5 per contract (the difference between the strike prices) plus the sum of average premiums on OTM calls which comes to about $5.88. The total possible loss, therefore, is about $11 per contract (transaction fees and taxes excluded). Adding back the premium received on ATM calls (about $8.4), we get a possible net loss amount of around $2.60 per contract. Given that the minimum amount you can transact is 100 options, this translates into a dollar amount loss of ~$260.
Because I think that VXX is very unlikely to stay this high for the next 49 weeks, and historical data show that it is rare, I think that there is a very high chance of this strategy earnings a nice amount in premiums. In order to minimize the potential loss, investors can buy closer OTM options. This, however, will incur a higher price. Keep this in mind.
More here: http://bit.ly/1202VXX1
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in VXX over the next 72 hours.