A few weeks ago, I wrote about a strategy that consisted of selling short out-of-the-money VXX calls. Before I was willing to short the calls, I wanted the IV on the VXX to be near all time highs and I also wanted there to be a pullback in the SPY. Both of those occurred today, therefore, I shorted the September $50 VXX calls. In this blog post, I will explain why I like this trade so much and how this strategy is much better than any other bullish strategy.
By selling options when the IV is high you have a big advantage. The reason is that the options are pricing in such a huge move that for the options to continue to gain in value, you need the underlying stock/ETF to have dramatic moves. More specifically, when the VXX has an IV that is almost at its year-high, it indicates that fear is at the highest level in almost a whole year. In turn, the calls, and more specifically, the OTM calls are very expensive because people are panicking.
As a VIX/VXX seller, you have to consider a few things. First, why is the market selling off? Second, what is your risk/reward on the trade? And lastly, how much more can the VIX rise before you feel that it will hit a top? The answer to all three of those questions at the current state of the market makes the short VXX trade very smart:
- First off, the reason the market is selling off is because of geo-political concerns. This is the best kind of sell-off because it always creates a fantastic buying opportunity. Every geo-political sell-off has been bought, as fears usually subside quite soon.
- Second, the risk/reward is very favorable because the options are priced very high and are extremely out of the money. To give you a better idea of the trade, I shorted the September 50 VXX calls @$1.00. The delta on the option is right now at $.18 and the Vega on the option is at $.03. The IV is at 80 and the average IV of the last year is at 60. This means that on any bounce (1-2%) in the market (SPY), the IV of the VXX should trade back down to 60 and the VXX should give back at least 5-10%. This would translate to a $.60 loss in the option due to the Vega and also a $.20 loss (at least) due to the Delta, making this trade on just one bounce over an 80% gain. Looking at my risk, the last few sell-offs in the SPY has lead to an average return in the VXX (during the correction) of around 40%.
- Lastly, the low on the VXX is 27.5, meaning that a 40% pop would lead to the VXX printing $40, still over 20% below my strike. What makes this even better is that the 40% pop has come on sell-offs of around 7%; this means that even if we were to get a 10% correction, it is still unlikely that it would touch my strike price. Even if it did touch my strike price, by the time it did, there would be a lot of money that would come into the market if we saw a 10% correction; this would result in major losses for the VXX at that point. All in all, I think the $50 strike is far enough away that it is safe to be a naked seller.
The reason I say that this is the best bullish strategy out there is because if you were to buy SPY calls, you would make very little, if anything, on a bounce; this is because the IV decline would destroy any gains. And it would not make sense to sell a put spread, because it seems as though there is still a little more downside in the SPY.
I will post another trade update when I close out the position, and reflect on how successful the strategy was.