By Jay Soloff
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I am at the MoneyShow in Las Vegas this week and it’s obvious that interest in options trading is growing by leaps and bounds. Every year, the crowd keeps getting larger. Plus, I notice more sessions and classes about options each time I come.
It always makes me happy to see the growing interest in options trading. Options are such powerful tools, and useful to all types of traders and investors. Plus, now that we have some market volatility resurfacing, it’s a very good time to be looking at options strategies.
The concerns over the trade war with China have spooked markets to some extent. We haven’t had an extended selloff per se. However, we’ve had some big down days. And, the VIX climbed over 20 early in the week. That’s generally a sign that investors are really starting to show concern over the market.
The tariff war has two likely possible outcomes. Either the situation gets resolved with a trade agreement between the US and China. Or, the can gets kicked down the road with a new “deadline” for getting the deal done. In the first case, volatility will plunge. In the second scenario, volatility will also likely come down, but more slowly and not quite as far down as the first case.
Either way, it is almost certain that volatility is going to be lower this summer than it is now. It also looks like the smart money is betting on something similar. In fact, one trade I came across this week is quite informative.
In the iPath Series B S&P 500 VIX Short-Term Futures ETN(VXX) – a popular instrument for trading short-term volatility – a large trader is betting that volatility isn’t likely to shoot substantially higher from current levels. More specifically, the trader sold over 21,000 June 28th 42 calls with the VXX just over $30 per share.
The calls were sold for $0.80, which resulted in $1.7 million of cash being taken in by the trader. As long as VXX remains below $42 by June 28th, all the premium will be kept by the call seller. Breakeven is at $42.80. Anything above that results in a loss.
Clearly, there is a massive amount of risk with this trade since there’s no cap if VXX skyrockets due to extreme volatility. However, the trader certainly understands the risk – people who trade 21,000 options at once definitely know what they are getting into in. As such, this strategist must have a strong belief volatility has a cap going into the end of June.
I also believe this is shrewd trade, although I would never sell naked calls. What’s more, if you’re not the type of person who is comfortable selling call spreads (my preferred strategy in this situation), you could easily buy a put instead.
The risk/return scenario with buying a put versus selling a call is different. Nevertheless, buying a put is a much easier and lower risk method of taking a negative view on volatility. For instance, you could buy the June 14th 28 put for about $1.50 with VXX at around $29.50.
By going two weeks earlier than the short call trade we just talked about, you are saving some money in premium (since you are buying, not selling in this case). Breakeven is around $26.50, with anything lower turning a profit.
That’s very much a realistic goal over the next month given how fast volatility tends to fall back to its mean level. More importantly, by buying the put, you are only risking that $1.50 per option. When it comes to risking $1.50 versus having unlimited risk… I’ll always choose the strategy with the defined risk.