A Better Way To Short Volatility

Buying put options in VXX has a superior risk to reward profile compared to shorting VXX shares by limiting risk and providing positive vega exposure.

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Profitable but Dangerous

Being short volatility has been one of the best trades in recent memory. The problem is that holding an outright short volatility trade can irreparably devastate a portfolio in the event of a market downturn. Therefore it is important to mitigate the tail risk of any short volatility position.

The upper graph shows the price of VXX in a regular scale. The lower graph shows the price of VXX on log scale.

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Vehicle of Choice

The short volatility trade can be accomplished in many ways. Some popular examples:

  • Short options on SPY or SPX
  • Long inverse volatility ETPs like SVXY, or XIV (before it crashed -90\% in one day)
  • Short VXX
  • Long VXX put options

We argue that outright shorting of VXX is very dangerous and should never be done. Our preferred method of shorting volatility is by buying put options on VXX, either outright or as a spread (buy one put, sell another put of the same expiration at a lower strike).

Practical Example

Assume you want to short $1mm worth of VXX, at today’s price of $27.62. This means you will have to short about 36,000 shares. This can be risky due to the potential for sharp short-term price spikes in VXX during market downturns. Some of the potential risks during one of these spikes are: high borrow rates, margin requirement increases, and (worst of all) the potential to have your borrowed shares called in.

Alternatively, you could buy puts. For example, the October 16th, 2020 $28.00 puts can be purchased today for $5.00 each. Purchasing 360 of these puts would cost a total of $180,000. This trade would have roughly half the short dollar exposure compared to the short VXX shares trade. However, the long put trade would only have a maximum loss of $180,000 compared to the unlimited maximum loss of the short VXX shares trade.

Positive Vega

The less obvious aspect of this trade is what happens to the VXX puts if the stock market crashes. As VXX spikes up, the positive vega exposure from being long options kicks in as a built-in risk mitigation feature. Positive vega exposure simply means that increases in the volatility of VXX have a positive impact on the price of the VXX puts. And in contrast to stock indices, VXX volatility tends to be positively correlated to VXX price.

Put a different way, when the market crashes, VIX spikes up which causes the "VIX" of the VIX (see VVIX) to spike up. This translates to a spike in the volatility of VXX which buffers the decrease in the VXX put's price and lessens the trade's loss. This "long volatility of volatility" property makes the long VXX put trade more robust to short-term market turmoil.

Conclusion

Options can offer a risk-defined way of participating in otherwise risky trades with a known max loss at the time the trade is initiated. The long VXX put trade is a good example of how we can use options to construct profitable trades without putting the portfolio in major risk.

Disclaimer: This report is for informational purposes only and does not constitute individually tailored investment advice. Alpha Insights is not a registered investment advisor.

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Dick Kaplan 2 years ago Member's comment

I  don’t think it’s a good time to short VXX. The market is going to get a pullback. Does it start Monday • Mid January • March… that’s the elephant in the room.

The key to shorting VXX is short it at the POP. Not down here at these prices. Watch the calls on Monday. Good luck