Today, I’m going to talk to you about one of my favorite option strategies.
Now, it’s not the sexiest one I trade… but it’s the most consistent and has made more money than anything else I have ever done with options.
And if you aren’t selling option spreads then you are missing out on a strategy that puts you in the driver’s seat.
Imagine trading a strategy that allows you multiple ways to win, has a statistical edge, high-win rate, and is considered one of the most conservative strategies you can trade.
You can play this strategy when stocks are selling off, raging higher, or even when they chop around.
It works great with individual stocks… but I’ve found that it’s even more effective with ETFs and ETNs… especially volatility ETNs.
And you know what?
Years ago, I came across one such treasure… a trade setup that seems to always work… and one that is easy to execute—once you learn the basic rules that I’m about to teach you.
First, you need to understand how volatility ETFs and ETNs work.
Leveraged volatility ETFs aim to match the S&P 500 VIX Short-Term Futures Index. The ETF or ETN attempts to mirror the daily movement, not day to day. That can leave long-term tracking off by a significant amount.
With the UVXY, you get a leveraged ETF that attempts to track the index by 1.5x. The VXX is an ETN that tracks the index one for one.
Both of these products will decay in value over time. You can see that in long-term charts for both below.
UVXY monthly chart
VXX weekly chart
Note: The VXX restarted in 2018 as an ETN. Otherwise, it would show the same long-term decline as UVXY.
I want to focus on UVXY. The stock’s price will decline over time. This occurs for two reasons. First, fees take their toll. This impacts both UVXY and VXX.
Second, mean-reversion coupled with daily tracking erodes the price over time. It works against leveraged ETFs or ETNs.
Here’s how it works out (and this applies to all leveraged ETFs).
- UVXY starts at $100, and the short-term VIX starts at $16
- The VIX climbs to $20, a 25% increase
- So the UVXY jumps to $100 x (25% x 1.5) = $137.50
- The next day the VIX drops back down to $16, a 20% decrease
- So, the UVXY declines to $137.50 x (1-(20% x 1.5)) = $96.25
Over time leveraged ETFs and ETNs that track daily performance lose value unless they consistently head in one direction.
We gain an advantage when we’re able to bet against the UVXY at or near the top.
So how do we find where that might be?
You need to understand the relationship between the VIX and VVIX to discern tops in the market.
The VIX measures the expected volatility in the market over the next year. A reading of $16 means the market expects a movement of 16%. The movement could be to the upside or downside.
But, the VVIX measures the expected volatility in the VIX over the next year. This is what’s known as a second derivative.
Here’s how it plays out. The VIX normally goes up when markets go down. When markets go up, the VIX goes down. Normally, the VIX will hover somewhere between $12-$16 most of the time (hence mean-reverting).
The VIX only tends to spike so high. While it got to above $80 during the great recession, readings over $30 are rare. Readings over $40 happen once every couple of years.
VIX weekly chart
Let’s compare that to the chart of the VVIX.
VVIX weekly chart
The key area to note sits between $115-$120. Once the VVIX reaches this point, the VIX tends to stall out. When the VIX tends to stall out, so does the UVXY.
The trade setup
Now that you’ve got all the pieces, I’m going to lay out the simple trade.
Our goal is to sell a call spread at or just in-the-money on the UVXY. We want to go out 21-30 days for expiration.
Selling a call spread requires the simultaneous sale of a call option at one strike price and the purchase of another call option at a higher strike price. This pays you a credit, known as the premium.
If price closes below the lower strike price by expiration, the options become worthless. That means you keep all the money you got paid.
Here’s an example of how this plays out.
The chart for the VVIX lists price in the middle of August above $115.
VVIX daily chart
At the same time the UVXY was making a high.
UVXY daily chart
Now picture the trade. You see the VVIX spike above the $115 mark into the zone. Let’s say you were late to the trade and sold a call spread at the close. That would have put you around $37 in the UVXY.
It still didn’t matter. The UVXY never got above $37 again. Any call spread you sold with a $37 strike as the lower strike price would have monied. Heck, even if you picked $36, you went out the 21 days you’d still have made money.
The best part is even if the stock goes nowhere, you sell at high implied volatility in the UVXY. That lets decays in IV work for you.
This trade doesn’t come around often. When it does, just give yourself enough time. If you want to be conservative, take a portion off when you’ve gotten partway to max profit.