by Tyler Craig | October 11, 2013 12:55 pm
Owners of long-term options can enhance returns and generate a little income along the way by harnessing the power of the calendar spread. Here, we’ll discuss how to do so via the iPath S&P 500 VIX Short Term Futures ETN (VXX).
As the name suggests, the strategy involves spreading the calendar by buying an option expiring in one month and selling an option expiring in another. To exploit the higher rate of time decay that creeps in near expiration, most traders buy longer-term options and sell short-term.
In addition to profiting from the day-by-day decay in option values, shorting near-dated options also provides a partial directional hedge. If the stock moves adversely, the gain from the short option helps offset the loss on the long option. To illustrate the concept, let’s explore how we could roll a recent long put suggestion on VXX into a calendar spread.
In light of the mini-fear bubble flaring up in the CBOE Volatility Index, I suggested purchasing a Jan 17 put on VXX for $2.90 to exploit an eventual drop in volatility over the coming weeks.
Well, we didn’t have to wait long as Thursday’s monster gap-up in equities popped the VIX bubble resulting in a swift 16% plunge in the VXX and insta-profits for put owners. The Jan 17 put rallied 34% to $3.90.
However, instead of simply holding onto the put for another couple months (which probably is a good idea), traders could look to tactically sell short-term OTM put options to generate some income along the way.
For example, if you think the descent in VXX is likely to slow in the coming weeks, you could sell the Oct 14-strike put expiring on Oct. 25 for 50 cents. Provided VXX remains above $14, the put will expire worthless, allowing you to pocket the premium, thereby reducing your cost basis and risk in the overall position from $2.90 to $2.40. As long as VXX remains above $13.50 (14 strike put minus the 50 cents), the calendar spread will deliver better returns over the next two weeks than the long put.
If you think VXX tumbles for a few days more, you could hold off on selling the Oct 14 put until the ETN shows signs of bottoming.
In the event VXX rebounds, the short Oct 14 put will help hedge the loss on the long Jan 17 put. Once October expiration passes, you could continue to look for tactical opportunities to sell additional OTM puts to further reduce the cost basis.
Remember, the ideal time to sell these is when VXX is poised to bounce or consolidate for a spell.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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