The Option Pit Method

Option Pit

Trading the volatility ETPs

Trading the Volatility ETP’s

What we will cover:• Intro and Trail of the VIX• Learning VIX zones: an Option Pit Exclusive• Pricing Volatility ETP’s• VXX/UVXY/XIV• SPY and VXX trading• Trade Structures • Trades for Monday

Trading the Volatility ETP’s

• The goal of our short course is a method for evaluating the Volatility ETP’s

• We will take into account realized volatility, time decay, VIX and VIX futures levels for VXX/UVXY/XIV/SPY/

This is not easy, but it can be if we think about it right

Trail of the VIX• The first thing to remember about the

Volatility ETP’s options is that they are:

options– on an ETP • From VIX futures – on the VIX index » from option volatility» on a cash index……... Aaaaahhhhhhh» That try to predict forward volatility

Trail of the VIX

Understand the VIX first!

Trail of the VIX

• The understanding comes from the unique character of VIX movement.

• The Option Pit secret is to think of VIX in Zones!

• Implied Volatility does not go up forever!

Pricing out the VIX Zones

•

Pricing out the VIX Zones

• VIX 10-13 Zone 1• VIX 14-17 Zone 2 • VIX 18-22 Zone 3 • VIX 23+ Zone 4

Pricing out the VIX Zones

• The idea of VIX zones helps quantify the trades from a reverting frame of reference– For instance: A Zone 1 trade has small downside

since VIX does not trade below 10 but could have giant upside potential

– We create Volatility ETP trades based on the Zone

Don’t forget realized volatility- Volatility Gravity!

How the VIX trades

Trading the Volatility ETPs

The most important thing to remember is that Volatility ETP’s are decayingassets and decay at different rates depending on the level of Contango

ButThey have a floor!

VXX/UVXY

• The VXX or the iPath S&P 500 short term futures ETN attempts to replicate being long VIX futures with a constant duration of 30 days

• The UVXY seeks to double the performance of the VIX near term futures– As you will see from the chart there is

considerable slippage in the product

VXX/UVXY

VXX/UVXY

Note that the VXX and UVXY decay on a daily basis because of Contango

Setting up strategy and time frame for Volatility ETPs

The investment decisions are based on time frame:

Longer Term of a 1 year duration: looking at ownership

Delta and Vega position- managing the direction by Vega

Shorter Term of a month or less: This is a trade looking to unwind

Gamma and Vega position- managing the direction by Gamma

This is so the average investor can be short term wrong but long term right.

Why Buy Options?

• Fallacy of buying options- you can never make money buying options

• If the market is moving faster than the implied volatilities are priced, option buying is almost always preferable.

Why? The options are pricing a

standard deviation move less than the market is actually moving.

VXX/UVXY

• Note the way the volatility products trade:

– The are long term crappy because of the roll yield issue

But- Short term they can have powerful moves up AND

limited moves down (can’t go to 0 in 1 day)So between VIX Zones and Term we can determine

useful ways to trade VXX/UVXY

Putting VXX/UVXY trade together

• What our the current conditions:

– VIX is in Zone 2 possibly on its way to Zone 1• In Zone 1 the downward path starts to slow down since

the VIX is near the bottom

• We could buy longer term OTM puts or• Create trades to sell shorter term OTM puts (1 x 2 ratio

trades or broken wing butterflies)

VXX broken wing fly for Zone 1 & 2

Roll Decay for 1.5 years

468 days at .07 per day is 32.76 which is below which puts VXX below 0

The problems are VIX can rise, futures can go into contango, no weekend decay but still A long term play is not a bad way to trade the decay

Long Term Puts

XIV

• XIV is an inverse VXX

What Zone does XIV become interesting?

XIV

• A nice trade in a higher VIX Zone• Fits in an IRA• Shorting Volatility with no option decay• When falling from one zone to another

• The Pitfalls are it can delist on a giant spike in volatility so protect or wait until VIX is already

dropping

VXX/UVXY

• Buying puts in VXX/UVXY is normally the best play if – VIX is crossing from a higher Zone to a lower Zone– Realized Volatility in the SPX has been high and is

starting to drop– There is heavy contango in the future products

All three conditions are optimal!

Advanced VXX- up Zone

• Because of VXX skew, upside butterflies are very cheap

Short Duration Positions SPY/VXX

Time to step in this week and get long?

You could be right you could be wrong!

What do we know? The market is moving

The implied volatility is moving up with it

The position is to own Gamma and at a minimumBe flat Vega- This is easy to test

Back to the Future Oct 3, 2011

Back to the Future Oct 3, 2011

• The price of 10 SPY Nov 109 straddle was 12.77.

• The price of 3 VXX Nov 57 Put was 7.25

• The vega on the straddle was 155• The delta on the VXX puts was -131

Back to the Future Nov 3, 2011

• The value of 10 SPY Nov 109 straddle was up around $4700.

• The value of the 3 VXX puts was up $2300

• The vega on the straddle was 25• The delta on the VXX puts was -285

Executing the Vega Neutral Straddle

• Why does this work? The volatility products follow the path of IV. – When IV jumps, they jump. This allows Vega to be

“neutralized” but have a positive curve

October 3rd, 2011 and Now

VIX can get much moreBackward than today

Executing the Vega Neutral Straddle

• First identify the market and capital allocation

• Try to keep the delta of the Volatility product part equal to the Vega of the long gamma part– If IV screams, this position will get long more Vega

• There is almost no negative theta when IV jumps

• The ideal close is when the one part pays for the other, then unwind the profitable part.

Market Conditions for the Vega Neutral Straddle

• Where can the straddle go?– Where is realized volatility?

• Where can VXX go?– Where is VIX and the VIX futures?

• What is the management routine?

VXX Put Profile

Today

Here is what this idea would look like today:

Wrapping up

• Understand the VIX acts differently• Learn the VIX Cascade• Check for a VIX Zone• Pick the right ETP for the job• From the Zone, pick the strategy• Use SPY and VXX in Zone 3 and 4

Thanks for attending!

Mark will be on next with a special offer at the end!

andrew@optionpit.com1(888) Trade-01