The current situation sets up an attractive options trade in the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX).
Ratio Call Spread
A ratio spread involves buying calls of a close-to-the-money strike and selling a greater number of out-of-the-money calls.
The goal is to greatly reduce the cost of, or even get a credit towards, the purchase of lower strike calls.
The optimal time to establish the position is when there has been both a strong move in the underlying security and an accompanying spike in the implied volatility (IV) of its options.
By contrast, you would probably not want to use a ratio spread before or after an earnings report. Before the report you'll have the high IV, allowing for a credit, but the move in the underlying stock has yet to occur. After the earnings report, and presumably the price move, IV will most likely be crushed and the ratio will be a net debit position.
The recent move in the VIX (INDEXCBOE:VIX), and by association the VXX, had both of these elements as they lifted some 20% from last Wednesday to Friday. Implied volatility on VXX options jumped from 55% to 100%. It is the high IV of the options that allows such positions to be established for a credit with a relatively small ratio.
The position I initiated Friday (March 14) involved buying one March $49 call and selling two of the $53 calls, which both expire Friday, March 21.
This 1x2 ratio spread could have been established for a $0.25 net credit. If the VIX is below $49 Friday (March 21), one would keep the premium collected.
But if volatility keeps lifting and VXX is at $53 on expiration, a maximum profit of $4.25 would be realized. That's the difference between the two strikes plus the $0.25 credit ($4 + $0.25).
However, the ratio spread has a naked component, meaning it carries unlimited risk if volatility keeps spiking higher.
So if the stock market crashed and IV surged to 150%, as it did in 2008, VXX would skyrocket and the position would have a disastrous loss.
This position's upside breakeven point is $55.25. Above that, losses start to accrue.
This is why ratio spreads are best established when both price and IV seem to have moved to relative extremes. The recent lift in the VIX and the spike in the IV of its options seemed to constitute an extended move, as a VIX above 20 is at the high end of past year. And IV near 100% is also a 52-week high.
This graphic shows the move in in both realized and implied volatility of the VXX.
Since the VIX is a statistical measure and usually mean-reverting, it doesn't really matter from what level the spike starts.
My bet is that we don't have a market meltdown this week, so I'll accept a small profit on no news. But there is also the possibility of concern, and a bid for protection remains in place, which could translate into a healthy profit.
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