One Way to Profit from Volatility’s Drop

The bullish launch of the equities market to kick off 2012 has been matched by an equally bearish beginning for the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX).  As of last Friday’s close, the popular volatility ETN was down over 26% for the year.

Coincident with the sell-off, the February bear-call spread we suggested in “A Bearish Play on the Volatility ETF to Start the New Year” has essentially maxed out its profit potential. But if you’re of the opinion that the current market uptrend has legs, you might consider reloading on bearish plays in the VXX.

Remember, if the S&P 500 (^SPX) continues higher, the CBOE Volatility Index (CBOE:VIX) should remain depressed … thereby helping to drive the VXX lower.

Source: MachTrader

One play worth consideration is the purchase of a put spread. The put vertical spread consists of “buying to open” a lower-strike put while “selling to open” a higher-strike put in the same expiration month.

This particular strategy presents a cheaper, lower-risk alternative to buying puts outright.  The potential risk is limited to the initial debit paid at trade inception, and the potential reward is limited to the distance between strike prices minus the debit.

One way to play this low-volatility trading environment would be to “buy to open” the VXX March 23 Puts while at the same time “selling to open” the VXX March 28 Puts for a net debit around $2.50. It doesn’t matter what you pay or collect for the individual “legs” of the trade, as long as you don’t pay more than $2.50 per share ($250 a contract) to establish the position.

At current prices, you could buy the March 23 Put for around $4.50 and sell the March 28 Put for around $2.25. As you can see, selling the higher-strike put can dramatically reduce your cost to enter the trade, and therefore reduces your risk accordingly.

The max risk is limited to the initial $250 ($2.50 x 100) debit, and will be incurred if VXX resides above $28 at March expiration.  The reward is limited to $250 ($5 – $2.50) and will be captured if VXX sits below $23 at March expiration.

At the time of this writing, Tyler Craig owned bearish positions on VXX.

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