OK, apparently caused lots of dissenting opinion in regards to slapping on a spread that involved going long VXX and short SPY near term options.

So let me clarify a few points.

This is just a convoluted way around a relatively simple trade, an SPX or SPY calender. So what if we forget VXX and VIX futures exist. The basic thought here is

when volatility caves, I generally would prefer owning calenders. That involves buying longer dated options at likely a higher volatility than I am selling the shorter term options. It gets me short gamma and earns money in the form of time decay.

You have to look at this as two separate transactions though. The short side of the options will earn me money if the realized volatility between now and expiration is less than the volatility I sold them for. Yes, part of that trade likely involves chasing stock into strength and shorting it into weakness. The idea is to lose less doing that than you earn in options attrition.

The long side of the calender is more of a bet on implied volatility at least holding steady. You will not lose all that much time decay, but you are at risk of a move lower in volatility. But if you think options volatility is a buy longer term, you are OK with that.

So combine the two and you are effectively betting on longer term implied volatility to outperform shorter term realized volatility. If you think that’s a good bet, a calendar makes sense.

Using VXX or a VIX future in lieu of a longer dated SPX or SPY option is not identical, but you will win or lose with it in a similar pattern as above.

But it’s important to remember however you chose to go long a longer dated option, it’s not a big deal if you “buy” higher volatility than you sell. It’s two different time frames and two very different bets, there’s no reason they will or should carry the same volatility. A few weeks ago they all did carry about the same volatility. That’s more unusual than not.

So what’s the risk in buying a calendar, or buying VXX and shorting SPY options?

It’s not that some small volatility difference between the two cycles will revert to 0. There are 2 big risks however. One is that realized volatility, which you are effectively shorting, will explode and longer term volatility will not lift as much. You would have got hit massively with that last Fall. Which is why I don’t like this position in a rising volatility environment.

The other risk is that all volatility caves in. Your short volatility will only earn you so much, I mean your options can only go to zero and you will get lousy prices trying to roll them. Meanwhile your VXX or VIX future or longer dated SPY straddle has gotten mauled.

Post getting long here. To be Continued.

Let’s look at some pictures.

Short Straddle

This is the profit and loss chart for selling a straddle, where the 175 call sells for $1.60 and the 175 put sells for $1.20. Total premium received is $2.80. If the stock ends the day at 175, that will be the return on the trade.

Since we receive $2.80 in premium, our break even points are $175 plus $2.80, or $177.80 and $175 – $2.80 or $172.20. Outside of that range, the trade loses money.

Return For A Short Straddle

Ratio Spread

What if instead of selling straddles we put on a ratio spread? That is, when the stock is at $175 we buy one in-the-money call with a $170 strike and sell three at-the-money calls with a strike of $175. The $170 call will cost $5 since it is deep in the money with no time left, and the $175 calls might sell for $1.60 as we saw above. In this case, we receive $4.80 and pay $5 so net we have to pay $0.20.

As you can see below, that is our exposure to the downside. If the stock rallies past $175, we are protected until the stock gets to $177.40. At that point, the 170 call that we are long is worth 7.4 and the three 175 calls we are short are each worth 2.4. So the three of them are worth -7.2 and we paid .2 for the position. So our break even point on the upside is $177.4 and on the downside $170.20.

Return for Ratio Spread

So the ratio spread has a wider range where it is profitable and very little downside risk. On the upside. it loses money faster than the short straddle.

If you wanted the mirror image of this return, $0.20 loss if the stock goes above $177 and the large losses if the stock falls below 170, Then you could buy the 180 for $5 put and sell four 175 puts for $1.20 each. This is more dangerous because we had to sell four puts to take in the same premium we got from three calls.

It all depends on where you think the danger lies.

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I sold some Priceline straddles today.

The Event

They are announcing earnings next Tuesday which makes the implied volatility high, around double the historical volatility.  I sold the options far enough away from where the stock is trading that I am protected from moves up to three or four standard deviations of one day price moves.  I also have time decay working for me.

It looks like a good trade.

We’ll see.

Time Decay

We’re going into a long weekend and next week is expiration week.  From the end of the trading day today, until options expire next Saturday at 5 PM, is 192.5 hours.  It is noon now in New York, so there are four and a half more trading hours left to Friday.  Then there is the rest of Friday night, seven and one half hours. Saturday, Sunday, and Monday is 72 hours.  So from the end of trading today there is 79.5 hours of weekend and nine and one half hours until the market opens Tuesday.  That gives us 89 hours out of the remaining 192.5, really we shouldn’t count the Saturday that options expire, since there is no trading on Saturday.  So that would give us only 168 hours until the end of trading Friday.  For 89 out of those 168 hours there is no trading.  That is a little more than half the time remaining.

But options are decaying as the clock is ticking.

Weekend Volatility

Volatility doesn’t go away completely over the weekends.  Remember the weekends last Fall when the Federal Reserve or the Treasury had a new plan to announce every Sunday.  That led to gap openings on Monday morning.  Typically, the volatility over the weekend is less than one half the weekday volatility.

Today is a good day to sell February series options.