A Volatility Play on the Return to Normalcy

Collect some fat option premiums now on this volatility ETF

   

With the S&P 500 (SPX) staging an impressive 15% rally to kick off the fourth quarter, many traders are hoping this surge turns into a trend change — one that finally ends the volatile correction that has played out over the past few months.

Given the dizzying twists and turns we’ve endured recently, I’m sure we could all use a little normalcy in the markets. If this turns out to be more than just another in a long line of failed attempts to return to an uptrending market, short volatility trades are starting to look more tempting.

With the Chicago Board Options Exchange’s Volatility Index (CBOE:VIX) still stuck in the mid-$30s and pricing in average daily moves on the SPX north of 2%, there is plenty of room for this volatility gauge to drop if we return to a more-stable market.

In such an environment, VIX futures would also fall from their lofty levels, which would place downward pressure on the popular iPath S&P 500 VIX Short-Term Futures ETN (AMEX:VXX), which lets you play volatility via an Exchange-Traded Fund rather than with the index it represents.

With fear still pervasive and demand for protection still rampant, upside calls in the VXX are trading at very high implied volatility levels. Such an environment makes the sale of out-of-the-money calls or call spreads particularly lucrative because option premiums expand with volatility.

But because selling call options without owning the underlying stock or a long call option as a proxy for the stock can be dangerous for individual investors, one good way to capture this call premium while capping your potential downside is with the bear-call spread strategy.

One bear-call spread I’m eyeing is the VXX November 60-65 Call spread, which you can currently enter with a 60-cent credit. That means you get paid upfront to make this trade!

To enter the position, you would “Sell to Open” the VXX Nov 60 Call (and collect a credit of $1.95, at current prices) while simultaneously “Buying to Open” the VXX Nov 65 Call (and spending $1.35, at current prices), giving you a net credit of 60 cents ($60 per contract).

If sold for a 60-cent credit, the max reward is $60 — the amount you collect upfront — which will be captured if VXX remains below $60 by November expiration.  The max risk is $440 (the difference between the spreads, $5 x 100, minus your $60 credit), which will be incurred if VXX sits above $65 at November expiration.

VXX 300x212 A Volatility Play on the Return to Normalcy

Source:  MachTrader

At the time of this writing, Tyler Craig had no positions on VXX.


Article printed from InvestorPlace Media, http://investorplace.com/2011/10/a-volatility-play-on-the-return-to-normalcy/.

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