Options Trading: Volatility Dislocation Creates Opportunity

Posted On February 7, 2018 12:14 pm
By: Steve Smith

As we discussed in yesterday’s article, there was a major explosion in VIX/Volatility related products that contributed to a negative feedback loop. This caused the VIX to surge and the ultimately the failure of several volatility ETNs were well beyond what should have occurred from a two day 6% decline in S&P 500 Index. For options trading, this was a serious disruption, but it also presents an opportunity.

The market dislocation caused by the ‘death’ spiral of XIV and other products makes it important to establish a bearish position the iPath S&P Volatility (VXX).

Historically the VIX would increase 5% for every 1% decline in the S&P 500. On Monday it surged over 100% or 3x what it “should” have.
Historically the VXX moves 2% for every 5% move in the VIX; meaning it “should” have risen approximately 45%. At its peak it was on Tuesday was up a whopping 80%.

While we may indeed be entering a higher volatility options trading regime (I mean, we could stay below 10 forever), I think VXX has overshot. Not only is it likely to revert to the mean, but it will likely also resume the downward trend caused by rolling of cantango futures.

Under a normal term structure, the VXX loses approximately 5% per month due to the rolling of the futures. This is why over time it approaches zero.

The TRADE:

-Buy VXX Feb (2/23) 43 Puts

-Sell VXX Feb (2/23) 39 Puts

For a Net Debit $2.10

Assuming volatility reverts towards its historical average of around 17 and the term structure resumes the natural cantango, VXX shares should drop by about 15% or towards the $37 level.

This would place the spread fully in-the-money, delivering a 90% return over the next two weeks.

Tagged with: options trading

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.