Summer Swoons
For whatever reason, most notably seasonality in economic data (something we’ve written about alot here at Risk Reversal) coming out of the financial crisis, the summer months have become one of the more volatile parts of the calendar for that past few years. Let’s first look at the SPX over the past few years:
The trend has been very calm starts to the year followed by increased worries du jour, whether they be related to Europe, domestic economic data, Fed speak in the summer months. Here’s a look at the VIX over the same time period with the summer spikes circled:
This year’s recent volatility comes in the form of mixed economic data, selloffs in Japan and emerging equity markets, wild currency moves, and bond moves here in the US. And to add to the uncertainty we have everyone guessing when the Fed will “taper” its QE program.
So how can options be used to protect and even take advantage of these recent spikes in volatility?
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Portfolio Hedging using SPY:
This is an easy hedge to put on against a long portfolio. The tradeoff is you are giving up upside on a large rally for the chance to hedge on any breaks from recent lows
Theoretical Portfolio Hedge: SPY (164.50) Buy the Aug 161/156 put spread, sell the Aug 170 call for even
- Buy 1 Aug 161 put for 3.15
- Sell 1 Aug 156 put at 1.90
- Sell 1 Aug 170 call at 1.25
This trade is selling a call above the recent highs to finance the purchase of a 5 dollar wide put spread that begins at the 50 day moving in case the market breaks that to the downside. Here are those levels on the chart:
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Portfolio Hedging with VIX:
Recently, we’ve noticed people referring to hedging by being long volatility as not really a hedge but just speculation on the VIX. I have a feeling that this viewpoint has something to do with the fact that ETNs that are intended to act as long volatility holdings are so terrible. Let’s look at some of the most popular:
VXX:
VIXY:
CVOL:
Let’s compare these to the spot VIX over the same time period:
As you can see, these are not good hedges, not even good speculative trades more than for a few days. As we’ve written extensively here on Risk Reversal, they should probably be banned.
- They do a terrible job at tracking actual volatility in the market as they’re more of a play on contango and backwardation within the VIX futures than on volatility in the market.
- Because contango is the default set-up within VIX futures these ETN’s bleed on a daily basis due to the roll of the futures from lower to higher during contango for most of their existence.
A trade we’ve been doing lately on the site and one that we really like is on the VIX futures’ options. Here was the last one we did in May when the market was near its highs and the VIX was under 13:
TRADE: Sold the VIX (12.87) June 14/12 Put Spread to Buy the June 16 / 20 Call Spread, Even Money
- Bought 1 June 12 Put for 0.08
- Sold 1 June 14 Put at 0.73
and
- Bought 1 June 16 Call for 1.23
- Sold 1 June 20 call at 0.58
The reason we like this structure is that we’re risking 2 dollars for the potential to make 4 on a spike in the VIX due to a market selloff, but since the VIX has difficulty staying at those low teen levels (rarely does it flatline at 12 for extended periods of time) we only really need one selloff in the market between the time of execution and VIX expiration for that trade to be profitable and get a chance to get out for a profit.
Here’s an interesting performance chart of that trade since early May until now that illustrates the point about the VIX having a difficult time staying at those levels at which we initiated:
This is typical action.
- It is possible to lose 2 dollars on that trade
- But less likely than the hedge expiring worthless or having at least one shot to get out for a profit.
If that structure is used against a long portfolio, its risk reward is even better as the conditions that would result in a VIX at 12 would mean the long portfolio is posting really nice gains.
- It’s a great hedge in that case with protection against the decay that would result in owning puts against the portfolio stocks and indices
- And also a much better position to have on over the course of a few months than the long Vol ETN’s highlighted above.
We ended up selling this structure out in 2 pieces for an average profit of 1.15 off the purchase at even.
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Short Premium Directional and Range Trading
What if you want to take a bet on a stock move or lack thereof but want to protect yourself against volatility falling or decay killing your position before you got your move? There a are a number of ways to do this, including:
- Selling out of the money options at places where you’d enter a long or short
- Doing a calendar spread to own an option while protecting against near term decay
- Positions such as Iron Condors that isolate a range
One of the trades that will be familiar to Risk Reversal subscribers is the In The Money Butterfly, something we’re fond of when we want to take a bet on a direction within a range and want to protect ourselves against near term decay (in fact we want to profit from it)
Let’s do a theoretical long delta trade in AAPL that takes advantage of short premium but defines our risk in a way that simply selling a put doesn’t. Let’s say we think AAPL is etsablishing a bottom down here in the low 400’s and probably has at least one run to 500 before the end of the year. A great way to play for this is through an ITM Fly centered at 500.
Here’s how it would look:
Theoretical Trade: AAPL (434) Buy the Jan14 400/500/600 call fly for 29.50
- buy 1 Jan14 400 call for 52
- sell 2 Jan14 500 calls at 12.50 (25 total)
- buy 1 Jan14 600 call for 2.50
Breakevens:
- At or below 429.50 lose up to 29.50, with total loss below 400
- profits above 429.50 with max gain of 70.50 at 500
- losses above 570.50 with total loss at or above 600
Here’s what that range looks like on a Payout Diagram:
- It’s a wide range of profitability
- You’ve essentially gotten long the stock slightly below where it is currently trading (429.50)
- You’ve defined your risk (29.50)
- You collect decay above 429.50
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Directional Trading With Doubts About Entry and Timing
Let’s say you’ve had your eye on a stock and have been waiting for a good entry point, but the market has seen a little volatility as it got to your spot. You want to pull the trigger but you’re a little afraid of being early. Calendars are something we like in this scenario. Let’s take the example of our recent QCOM trade:
Trade: QCOM ($61.47) Bought the July/Aug 65 call spread for .62
- Sold July 65 call at .42
- Bought Aug 65 call for 1.04
QCOM was a name we’d had our eye on during its recent weakness but as it got close to the spot we like for a long delta play it looked really ugly and with continued overall market weakness could have been setting up for breaking recent support:
In this case we liked the calendar call spread at the point we were ready to get long because selling the July call to finance the August protected us from a break of support (which could then become resistance that could last a few weeks to a month) or if it simply consolidated near the entry point.
- Protects against decay as a stock consolidates at your entry level
- Gives numerous ways to win as the front month decays at a faster rate than your back month
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