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Part 2: When Is The Best Time To Start Trading A Volatility Strategy?

|Includes: ProShares Short VIX Short-Term Futures ETF (SVXY), UVXY, VXX, XIV

In our last post, we shared our thoughts and ideas on the most opportune time to start trading a volatility strategy. If you have not read that post yet, please start here before continuing.

Ok, now that we're all on the same page, let's move on.

For Part 2, we wanted to describe two possible improvements to the 'option assignment method' described in Part 1.

Possible Improvements

-Scale into your position

  • You can scale into your position by selling options at varying strikes prices, varying expirations, or both.

-Sell Call options to scale out of a long position if assigned on short put

  • Similar to selling put options and hoping to get assigned (creating a long position in the underlying), you can sell call options hoping to get your position called away once assigned.
  • Choose a strike price at which you would want to sell your long position
  • If the underlying (SVXY in our examples) does not reach the strike price by expiration, you collect 100% of the option premium - earning you more money than if you had just held your long position.
  • If the underling (SVXY in our examples) trades above than the strike price at expiration, you effectively sell the underlying (get called away) at a price you wanted to sell at anyways, AND earn 100% of the option premium.

To be clear, there are probably an infinite number of other ways you could improve our original method. We simply wanted to present you with a few simple ideas. Further, we purposely called them "possible improvements", as you may be worse off implementing these "improvements" compared to sticking with our method outlined in Part 1. There are pros and cons to everything, and it is up to you to decide what is best for you.

With that said, let's walk through some real-world examples, with actual option pricing:

Example 1 - scaling in using multiple strike prices

Date: 6/24/2016

Event: Day after Brexit Vote

SVXY Drawdown: 35% from recent high on 6/7/2016

SVXY Price: $43.13

Position:

-Sell 1 of the 7/1 38 strike puts for $2.00

-Sell 1 of the 7/1 36 strike puts for $1.35

-Sell 1 of the 7/1 34 strike puts for $0.90

Time of Entry: 3:55pm ET

SVXY Price Graph 6/24/2016

Short Options Payoff Profile

Economics: You're effectively committing yourself to getting long 100 shares of SVXY at $33.85 ($38 strike - $4.15 total premium), or 21.5% lower than the current price, and nearly 49% lower than the recent high, if SVXY trades between $38 and $36 at expiration. If SVXY trades between $36 and $34 at expiration, you're effectively committing yourself to getting long 200 shares at $34.93, or 19% below the current price. Finally, if SVXY trades below $34 at expiration, you're effectively committing yourself to getting long 300 shares of SVXY at $34.62, or 19.7% below the current price. To look at it another way, you're earning a 35% yield if all the options expire worthless (if SVXY trades above $38 at expiration).

Overall, you're scaling into your position as the drawdown gets steeper and steeper, and you're getting paid to do so (by collecting the option premium). From a mental standpoint, this reduces the hesitation you face entering a position during a drawdown when you invariably ask yourself, "will this drawdown continue, or is now a good time to invest?".

SVXY Price Graph 7/1/2016

On 7/1/2016, SVXY traded at 50.59. Your short options expired worthless, and you earned 35% on your capital. Hooray! In this example, you did not end up getting assigned (you did not end up getting long SVXY), but you're still probably pretty happy to earn the entire options premium.

Example 2 - selling call options once assigned

Date: 10/28/2016

Event: Upcoming US Presidential Election

SVXY Drawdown: 10% from recent high on 10/24/2016

SVXY Price: $73.45

Position: Sell 1 of the 11/4 68 strike puts for $0.85

Time of Entry: 3:55pm ET

SVXY Price Graph 10/28/2016

Short Option Payoff Profile

Economics: You're effectively committing yourself to getting long SVXY at $67.15 ($68 strike - $0.85 premium), or 8.6% lower than the current price, and nearly 17% lower than the recent high, if SVXY trades below $68 at expiration. To look at it another way, you're earning a 9% yield to potentially get long SVXY at $68 if SVXY trades below $68 at expiration.

SVXY Price Graph 11/4/2016

On 11/4/2016, SVXY traded at 64.35. Your short option expired in the money, so you got assigned 100 shares of SVXY. You are now effectively long SVXY at $67.15. Let's sell a call option against our 100 share long position, effectively getting paid to hopefully have our shares called away at a higher price.

Date: 11/7/2016

Event: Just got assigned 100 shares of SVXY (we are now long 100 shares at $67.15)

SVXY Price: $70.63

Position: Sell 1 of the 11/18 80 strike calls for $1.15

Time of Entry: 9:35am ET

Short Call / Long SVXY Payoff Profile

Economics: You effectively converted your 100 share long position into a covered call position. You're committing yourself to selling your 100 shares at $81.15 ($80 strike price + $1.15 premium) if SVXY trades above $80 at expiration on 11/18. Further, your break-even price on your 100 shares is now $66 ($67.15 effective entry price - $1.15 premium).

SVXY Price Graph 11/18/2016

On 11/18/2016, SVXY traded at $81.62. Your short call expired in the money, causing your shares to get called away at an effective price of $81.15 (presumably a price at which you would have wanted to sell at anyways). In the time between getting assigned on your short put and then having your shares called away by your short call (roughly 3 weeks), your position earned 21.37%. You accomplished two things: you started a volatility strategy during a drawdown (the "concrete answer" from Part 1 as the best time to get started), and you got paid (you collected the option premium) to sell your position at a price at which you wanted to sell at anyways.

Of course, not every situation will be as "clean" as in our examples - you may face addition drawdown after getting assigned on your short put, or it may take longer than you anticipate to get your shares called away by your short call. You should already be prepared for this before implementing these methods, however.

Summary

We highlighted two (out of many potential) possible improvements to our option assignment method for timing the start of a volatility strategy. Scaling into your position using multiple strikes and/or expirations, and selling call options against your long position (once assigned), may be of benefit to you.

Implementation

While we believe this is a great method, one of the main problems of trying to time the start of a volatility strategy is that you may end up waiting a long time for a drawdown to occur. During this time, you are likely leaving money on the table by sitting on the sidelines (you give yourself less time to earn the long-term statistical edge). We believe the best way around this is to start trading with a "core position" (do not wait for a drawdown on this position) and simply add to your core position during drawdowns using the option assignment method outlined above. This way you give yourself maximum time to earn the long-term edge, while also investing more money at favorable prices during drawdowns (or getting paid to wait if not assigned).

**You can start trading a core volatility position today by following along with our Roll-Yield + VRP strategy (up 154% YTD as of 12/27/16), and also receive discretionary ideas to add during drawdowns / scale out once assigned, using the option assignment method we've outline in our posts.

Disclosure: I am/we are long XIV.