VIX FUTURES: Abusing Volatility 1/2
We find alternative financial instruments to generate income in downward trending markets.
Volatility always reverts to the mean.
UVXY could make it rain in stormy times like these.
1. Why Do I Care Right Now?
Ever thought about how to make a difference in a market with no clear direction or trend to the downside? Side-way movements can be sustainable if the underlying asset distributes a fair chunk of dividends. Still, a bear market or declining asset prices for a prolonged period is a tough pill to swallow. Modern markets seem highly correlated, especially on the way down, and alternative investment ideas are usually not easy to find.
One could bet on falling asset prices by selling short or using derivatives. However, being short is a dangerous game and only for the most skilled and patient warriors amongst us. Open a 10-year monthly graph of nearly any primary market index or ETF and imagine how successful your shorting would have been. Bear markets generally seem to be short-lived. So, let’s see if we can find a liquid financial instrument that we can ‘abuse’ in times of unclear or more shaky markets.
2. Useful Background Information
Check out the CBOE Volatility Index (VIX). It reflects the implied volatility of the S&P 500. One can calculate the implied volatility for any traded asset. Yet, the beauty of VIX is that one can trade these volatility futures and liquid option chains on them. VIX is not the only liquid and tradable volatility product. There are ETFs like VXX and UVXY, which mirror the movements of the VIX. In short, we can use option maths and probabilities to our advantage on all three products!
Now, let’s get more practical and see how we can implement our findings. Since implied volatility is mean-reverting within an average time frame of, let’s say, less than four weeks, we should be able to structure our option products reflecting that assumption. My favorite underlying is UVXY, which has excellent liquidity, slightly better risk/ return ratios, and the highest capital efficiency. My best guess for a mean-reverting price at current levels would be 15.
3. Trade Execution
There are many ways how to play a mean-reverting UVXY using options contracts. However, considering all option pricing variables, the most promising strategy is short 15 iron condor, same strike, 17 Jun expiration.
We define risk to the upside by getting long the 30 Call, and to optimize capital efficiency, we also buy the 5 Put; the latter should not cost more than 1 cent. The overall credit received is 5.90, and we should be able to buy back that iron condor for less than half the credit received if the price mean reverts to somewhere between 13 and 17 within the next six weeks. Break-evens are 20.90 (15 strike + 5.90 credit) and 8.10 (15 strike - 5.90 credit).
Trade Entry - May 2, 2022
1) Short Call 15, Jun 17, 2022: 5.30 Credit.
2) Short Put 15, Jun 17, 2022: 2.40 Credit.
3) Long Call 30, Jun 17, 2022: 2.46 Debit.
4) Long Put 5, Jun 17, 2022: 0.01 Debit.
Total: 5.90 Credit.
See below the exact trade details and pay-out analysis.
The trade was modified on 3 May. 30 Call 17 Jun was moved five strikes lower to 25 Call 17 Jun. This resulted in a positive effect of maximum profit (/return) = maximum loss (/risk). Capital employed decreased by 35%, and therefore capital efficiency improved.
4. Final Comments
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