How To Make Money On The Huge Spike In Volatility

High Volatility, Options, Profit from the Headlines

What a difference a week makes. That’s both the beauty and danger of the financial markets. They largely generate wealth over time, but will occasionally remind you that they can take it all away at any time.

At the time of this writing, the S&P 500 had dropped 10% from its highs, which puts the markets into official correction territory. And while stocks are obviously taking it on the chin, it’s the spike in volatility that has really been noteworthy.

Perhaps the biggest thing to come out of this correction is the death (at last temporarily) of the extremely popular short volatility trade. Because yields on fixed income have been so low, many funds have shifted to selling volatility in order to generate income.

Obviously, anyone very short volatility was in deep trouble after this past week. I expect several short volatility funds may be liquidated, with many others taking severe losses. It’s the liquidation of short volatility positons which may be a major contributing factor to the continued market meltdown.

Nevertheless, the market will return to normal behavior eventually, like it always does. What I mean by normal is volatility will at some point (likely in the next couple weeks) become more profitable to sell than to buy. How to make money on short volatility moving forward remain to be seen. Given the catastrophe suffered by many short volatility players this time around, I won’t be surprised to see things change to some extent.

In other words, shorting VIX-based ETPs (exchange traded products) may not be so popular for the time being. Maybe that means buying puts in VIX options or VIX ETPs. Maybe it means selling VIX futures. Perhaps some new short volatility products will be released. We won’t know for sure until we start seeing the action.

However, at least one size-trader, with a lot of courage, is taking a very interesting approach to the short volatility trade. This trader is taking a very large short call position in iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). VXX is the most popular of the VIX ETPs out there, averaging over 40 million shares traded daily.

With VXX at $50, someone sold the June 15th 95 calls for $4.45, over 13,000 times. Open interest in the 95 strike was very low, so this is clearly an opening trade. Even though $95 is a long way from $50, June is also a long time from now (to be effectively short so much volatility).

Of course, short calls means unlimited risk (although there’s certainly a cap on how high volatility can go). On the other hand, the trader is taking in a whopping $5.8 million in premium on the trade.

If you have a big margin account, I don’t think this type of trade is a bad idea. Volatility spikes tend to be short-term in nature. However, this is too risky a strategy for most traders. As such, I recommend buying a put spread in VXX instead.

Now, puts are more expensive with volatility at high levels, so make sure you look at put spreads and not naked puts. For example, the VXX March 16th 40-45 put spread (buying the 45 puts, selling the 40 puts) would cost around $1.90 with VXX at $55. Max loss is only the $1.90 paid for the spread, while max gain is $3.10.

Doing some quick math, that shows potential max gains of 63%. That’s not a bad risk/reward scenario at all for a roughly 5-week bet on volatility returning to lower levels. And, it’s certainly a lot safer than selling calls.

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