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Now May Be A Good Time To Sell Volatility

|Includes: SPY, iPath S&P 500 VIX Short-Term Futures ETN (VXX)

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%:

(Source: ​Option-price.com)

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.