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Vol Whisperer: Volatility Unleashed

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January 9, 2017
volatility unleashed
Fredrik Broden

Want to learn a funky twist on a traditional investment? If you have a futures account and understand what the CBOE Volatility Index (VIX) is, you might be ready for a covered call in volatility (“vol”). That’s long /VX futures and short VIX calls. This helps you think about vol as an asset class where you’re taking strategic positions. Just like you might sell covered calls against your stocks, or even bonds, you can start to treat vol in a similar way. Note that I say “similar” because there are nuances that can make this strategy funky. Not harmful or scary or bad. Just funky. Stick with me. It gets clearer.

Nuance One: Same Expiration

You can’t trade the VIX itself. So VIX option market makers use /VX futures as a hedge. That’s the key to understanding this approach. The value of VIX options is determined by the price of the /VX future in the same expiration. The Feb VIX call options are priced off the Feb /VX future, Mar VIX call options are priced off the Mar /VX future, etc. You want to sell calls in the same expiration as the /VX future, so don’t mix them up. That could expose you to greater risk, because the /VX futures in different expirations don’t always move up and down at the same rate.

Nuance Two: Cash Settlement

At expiration, VIX options and their corresponding /VX futures are cash-settled according to VRO, which is the expiration settlement symbol for the VIX. If your short VIX call is in-the-money (ITM) at expiration, the difference between the option’s strike price and VRO will be deducted from the cash in your account. If the short VIX call is out-of-the-money (OTM) at expiration, you keep the credit as cash. The /VX future will turn into a cash equivalent of $1,000 x VRO.

With VIX options and /VX futures, the position disappears at expiration. You’ll need to reestablish the position after expiration, and that means more commissions. Keep that in mind.

Nuance Three: Multiplier Sense

Finally, you sell 10 VIX calls against one long /VX future. That’s because VIX options have a $100 multiplier. If you sell a VIX call for $1.50, you get a credit of $150 in your account (not including commissions). The /VX future has a $1,000 multiplier. If you buy a /VX future for $13 and sell it at $14, that’s a $1,000 profit. Because the /VX multiplier is 10 times bigger, you would sell 10 VIX calls against it. These subtleties are vitally important. As you gain more experience with these trades, you might sell fewer than 10 calls against the long /VX to have more bullish exposure. But start with 10 short VIX calls versus one long /VX future.

Why Bother?

If you think vol might go up over time, this strategy lowers the breakeven point of a long /VX position, which could help weather the periods when vol is persistently low. Plus, it can add another level of portfolio diversification. So study up and consider putting into play the various nuances, then wear a T-shirt boasting about your smarts as a vol asset-class trader. You could be the first on the block.

To learn more about trading covered calls, check out this article, "The Trader's Cure for the Volatility Blues" from thinkMoney31.

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