Signs of a Coming Fall? Three Ways to Play Volatility With Options
On the surface, it seems fairly logical and straightforward to use VIX-related products, but there are other possibilities.
Before we get into ways to play or protect against an increase in volatility, it’s important to define what we mean by that term. The VIX (INDEXCBOE:VIX) is the most widely used gauge of market volatility. It is a measure of the 30-day options on the S&P 500 (INDEXSP:.INX). An increase in the VIX, or implied volatility of SPX options, is typically associated with a decline in the market as investors bid up the price of put options to protect their portfolio. And while this is usually true in practice, it is not accurate regarding the definition of volatility. Volatility, both realized and implied, is not directional. It is the measure of realized or expected (implied) market moves, up or down, in a given time frame.
As you can see from the chart below, the VIX did indeed spike during market sell-offs, particularly during the 2008-2009 financial crisis. But note that it also trended higher from 1995-2000, even as the S&P 500 enjoyed an historic bull run fueled by the dot-com euphoria. During that period, many people were actually fearful of missing the upside and therefore were bidding up the price of call options.
On the surface, it seems fairly logical and straightforward to use VIX-related products (note that you cannot buy the actually VIX as it is just a mathematical index), such as futures, exchange-traded notes (like the iPath S&P 500 VIX Short Term Futures (NYSEARCA:VXX)), and all the related options if one is expecting a market decline. But it is crucial to understand that the VIX itself is mean reverting, and the related products are priced off of futures, which ultimately must converge. The VIX futures typically have a forward skew in which the later dates carry a premium. The result is that the VXX, and other such products, have a downward bias and theoretically will approach zero over time.
Add to this headwind the fact that the VIX family doesn’t always respond in unison or as expected to market moves. In a recent article, Adam Warner, an expert in all things VIX, provides a mouthful of an explanation as to why volatility-based products, such as the VXX, are difficult to trade or use as hedges:
I’m not trying to dissuade you from using the VIX as a means of trading or hedging against volatility; I am just suggesting that you understand the nuances of this asset class. That said, one of the main advantages of buying the VXX versus put options on the SPX or SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is that you are not anchored to a specific price level of the underlying index. This means that implied volatility will pretty much pop the same amount if the S&P 500 were to tumble 5% in a two-day period from the 1600 level as it would from the 1700 level. If you were to buy puts and the market climbed for a few weeks, those puts would move out of the money and have a much lower delta if the index declined from a higher price, thus providing less protection.
The Back Spread
Let’s look at one my go-to strategies for bracing for a sharp sell-off: the back spread. A back spread consists of selling near-the-money options and buying a greater number of out-of-the-money options, typically with the same expiration date. For example, with the SPY trading at $170, one could:
- Sell one October $168 put for $1.50 per contract.
- Buy two October $165 puts for $0.70 per contract.
This 1x2 spread would therefore be done for a $.10 net credit. The sale of the higher price put finances the purchases of the lower strike. In that sense, it offsets the impact of time decay. This means that if the SPY is above $168, both options will expire worthless and you will collect that $.10 of premium.
But this position is really about capitalizing on a sharp market decline. Let’s break down how it works. The position starts with a delta of -0.12 or the equivalent of being short 120 shares. But it has a positive gamma, which means that, as the underlying SPY price declines, delta becomes more negative and the position becomes more bearish or shorter. It will also benefit from the rise in volatility that should accompany a steep decline.
This strategy can be tweaked by adjusting the ratio and the width between strike prices. One of my favored approaches is to sell later-dated near-the-money puts and then purchase a much greater number of near-term slightly further out-of-the-money puts.
For example, one could start with selling the October $168 put in the above example then buy three $167 puts that expire on October 11 for $.50 each. This is an even money position (no cost), but because the ratio is greater and the width between strikes is narrower, it has a higher delta and gamma. The options with the closer expiration dates will also see a larger spike in implied volatility should there be a sell-off. The trade-off is that the later-dated options will not decay as quickly, so there is theta risk. That makes timing, not just market direction, crucial.
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