OPTIONS TIP: WHEN/HOW TO MECHANICALLY SHORT VOLATILITY
There are two types of VIX or VIX product (i.e., VXX, UVXY, and SVXY) trades that I like: (a) "Term Structure" and (b) "Contango Drift" trades.
"Term Structure" Trades
"Term Structure" trades are only done in VIX, since only VIX has an underlying future (/VX) and a "term structure," with /VX futures prices generally priced at increasingly higher prices as you go further out in time. While these trades do benefit from contango, they are set up using the /VX futures term structure (not VIX spot price). In that sense, the price of VIX is somewhat irrelevant to these trades, although you'll naturally find that if spot is elevated, the futures price in the expiry in which you want to set up your trade is, too.
My entries are straightforward: (a) find the /VX front month futures price >16 and in an expiry that is <90 days out; (b) sell a short call vertical spread with the short call aspect at/near the /VX futures price in the expiry that corresponds to that of the /VX future (i.e., if the /VX future >16 is in Dec, sell the VIX short call vert in the Dec expiry with the VIX short call strike at 16 and the long call out from that strike).
You can naturally go lower (i.e., the 15 strike), but I view the 16 level as a fairly long term average level that I'm comfortable working with. As far as the width of the spread is concerned, that will be subjective. The wider you go, the more the max loss potential -- keep your risk consistent with your per trade risk tolerance. To give you some sense as to what to expect out of these: look for .70-.80/contract on a three-wide and look to take profit at 50% max.
"Contango Drift" Trades
The vast majority of the time, VIX is in contango. What does this mean? Without going into too much detail as to "why this is so" and at the risk of oversimplifying things, it basically means that products like VXX and UVXY decline over time in the absence of backwardation. Backwardation -- where near-term futures prices or spot is actually higher than longer-dated futures -- doesn't occur all that often, so the general, overall, long-term drift of these instruments is toward zero, with occasional reverse splits being necessary to prevent them from ceasing to exist. That being said, these instruments experience spikes just as VIX does; it's just that -- on average, over time -- they decline in value, and "Contango Drift" trades look to benefit from that fairly inevitable decline.
Entries here are also straightforward, but some patience is required to wait for the right metrics to occur -- a VXST/VIX ratio of greater than 1.0. The higher the ratio, the better. When that ratio is greater than 1.0: sell a short call vert in either VXX or UVXY (a) in a 45 days until expiry or greater; (b) with the short call aspect at the first in-the-money strike; and (c) the long call aspect as wide as your per trade risk tolerance permits. With SVXY, an inverse, do the opposite: sell a short put vert (a) in a 45 days until expiry or greater; (b) with the short put aspect at the first in-the-money strike; and (c) the long put aspect as wide as your per trade tolerance permits.
With these, I attempt to get 1/3rd the width of the spread in credit, so for a three wide, you should be seeking a 1.00 in credit; a four-wide, 1.25, etc. Liquidity in these instruments -- particularly in UVXY and SVXY -- can sometimes be "pesky" with wide bid/asks, so you frequently need to shoot for a mid price fill and then walk your fill price in incrementally to get filled. As with the "Term Structure" trades, I shoot for 50% of credit received for these.
1 -- Assuming that VIX is in contango.
2 -- SVXY, an inverse, increases over time.
3 -- SVXY, an inverse, "regular" splits.
4 -- I personally like something north of 1.15, but it's hard to hit these spot on.
"Term Structure" Trades
"Term Structure" trades are only done in VIX, since only VIX has an underlying future (/VX) and a "term structure," with /VX futures prices generally priced at increasingly higher prices as you go further out in time. While these trades do benefit from contango, they are set up using the /VX futures term structure (not VIX spot price). In that sense, the price of VIX is somewhat irrelevant to these trades, although you'll naturally find that if spot is elevated, the futures price in the expiry in which you want to set up your trade is, too.
My entries are straightforward: (a) find the /VX front month futures price >16 and in an expiry that is <90 days out; (b) sell a short call vertical spread with the short call aspect at/near the /VX futures price in the expiry that corresponds to that of the /VX future (i.e., if the /VX future >16 is in Dec, sell the VIX short call vert in the Dec expiry with the VIX short call strike at 16 and the long call out from that strike).
You can naturally go lower (i.e., the 15 strike), but I view the 16 level as a fairly long term average level that I'm comfortable working with. As far as the width of the spread is concerned, that will be subjective. The wider you go, the more the max loss potential -- keep your risk consistent with your per trade risk tolerance. To give you some sense as to what to expect out of these: look for .70-.80/contract on a three-wide and look to take profit at 50% max.
"Contango Drift" Trades
The vast majority of the time, VIX is in contango. What does this mean? Without going into too much detail as to "why this is so" and at the risk of oversimplifying things, it basically means that products like VXX and UVXY decline over time in the absence of backwardation. Backwardation -- where near-term futures prices or spot is actually higher than longer-dated futures -- doesn't occur all that often, so the general, overall, long-term drift of these instruments is toward zero, with occasional reverse splits being necessary to prevent them from ceasing to exist. That being said, these instruments experience spikes just as VIX does; it's just that -- on average, over time -- they decline in value, and "Contango Drift" trades look to benefit from that fairly inevitable decline.
Entries here are also straightforward, but some patience is required to wait for the right metrics to occur -- a VXST/VIX ratio of greater than 1.0. The higher the ratio, the better. When that ratio is greater than 1.0: sell a short call vert in either VXX or UVXY (a) in a 45 days until expiry or greater; (b) with the short call aspect at the first in-the-money strike; and (c) the long call aspect as wide as your per trade risk tolerance permits. With SVXY, an inverse, do the opposite: sell a short put vert (a) in a 45 days until expiry or greater; (b) with the short put aspect at the first in-the-money strike; and (c) the long put aspect as wide as your per trade tolerance permits.
With these, I attempt to get 1/3rd the width of the spread in credit, so for a three wide, you should be seeking a 1.00 in credit; a four-wide, 1.25, etc. Liquidity in these instruments -- particularly in UVXY and SVXY -- can sometimes be "pesky" with wide bid/asks, so you frequently need to shoot for a mid price fill and then walk your fill price in incrementally to get filled. As with the "Term Structure" trades, I shoot for 50% of credit received for these.
1 -- Assuming that VIX is in contango.
2 -- SVXY, an inverse, increases over time.
3 -- SVXY, an inverse, "regular" splits.
4 -- I personally like something north of 1.15, but it's hard to hit these spot on.
Comment:
Because of contango, I regard the following trades as "generally bad ideas": VXX/UVXY covered calls or SVXY covered puts (contango drift); VXX/UVXY short put verticals or SVXY short call verts (again, contango); any nondirectional trade (again -- you guessed it -- contango). They can work given a VIX spike of a particular magnitude, but statistically don't.
