A Cheap Way To Hedge Against Higher Volatility

High Volatility, Low Risk Investments, Options

One of the great things about options is how flexible they can be. Traders can mix and match options contracts to custom create strategies which suit their needs. It’s a particularly valuable feature for precisely defining the amount of risk a strategy can have.

Being able to define risk (i.e. decide how much you are willing to lose if the trade goes against you) is especially important when options are expensive. When the market is more volatile, options become more expensive – and thus is becomes more difficult to adequately hedge your portfolio without overpaying.

If you are willing to cap the amount of gains your hedges can earn, you can significant lower the cost of the hedge – in other words, lower your risk. My favorite way to cheaply hedge a portfolio is by using a butterfly strategy.

An options butterfly is a 3-legged trade where you buy (sell) the “wings” and sell (buy) the “guts” twice as many times. That means the strategy takes the form of 1x2x1. For example buying a 50-55-60 call butterfly in stock means you are buying 1 each of the 50 and 60 calls, and selling 2 of the 55 calls.  Selling a butterfly would be the same thing in reverse.

Buying a butterfly like the one I described can be used as a directional trade if you place it out-of-the-money. In the case of a call butterfly, you would place it above the current stock price and hope when the options expire the price is equal to the middle strike (the one you sold twice as much of).

The benefit of a butterfly spread is that you are lowering the cost of the trade because you are selling the middle strike twice as many times as you are buying the outside strikes. The challenge is you need to the stock to finish within the range of the outside strikes to make money, with max gain at the exact center.

What’s intriguing is someone used a call butterfly in iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) this past week as a short-term hedge against a 20% or so spike in volatility.

VXX is an exchange traded product which tracks the first two futures month for the VIX. It makes it easy for just about anyone to trade short-term volatility just like trading a stock. That’s why VXX is very popular and heavily traded.

By purchasing an out-of-the-money call butterfly in VXX, the strategist is hedging against (or possibly betting on) a higher move in volatility, but not too high. More specifically, the trade is the November 30th 42-45-48 call butterfly, placed with VXX at just around $39, for a cost of just $0.22.

That means the VXX needs to be between roughly $42 and $48 on next Friday’s expiration for the trade to make money. The max gain on the trade is at $45, where the trader would make the distance between the wings and center, or $3, minus the cost of the trade ($0.22) for a total of $2.78. Max loss is only the $0.22 spent on premium.

The strategist placed this trade 12,000 x 24,000, x 12,000 times, which is about as big of a butterfly trade as you’ll ever see. It also means the max loss on the trade is $264,000, but max gain could be as high as $3.3 million. While max gain isn’t likely, the strategy technically makes money anywhere between $42.22 and $47.78, which is a pretty wide range for such a cheap trade.

I love using butterflies as a hedge against volatility, just like this trade does. If you believe there’s a cap on high how VXX can go (which is reasonable since volatility is already much higher than normal), this is nearly an ideal way to hedge. Plus, if you want to buy more time, you could easily the December 7th butterfly at the same strikes for just about $0.25!

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